Toys R US vs KB Toys | Tears 'R' Us | 4

0:08January 14th, 2004, just before 9am, Pittsfield, Massachusetts. A KB Toys employee turns off West Street and into the parking lot of the company's headquarters. She's late, held up by the snow piled up in her driveway. She pulls into a spare space and races toward the entrance of KB's three-story head office. She senses something's wrong immediately. There's no one at reception. She heads down the corridor. The place is like a ghost town. Then she hears talking, and it's coming from the cafeteria. She heads in. The place is packed. Everyone's assembled, and it's standing room only. She squeezes into a space next to a colleague who's lined up against the wall.

0:52What's going on? Not sure yet. They just called us in. You think today's the day? The man doesn't reply, but he knows what she's talking about. Rumors have swirled around the office for months that KB is about to go bankrupt. And that was before Walmart's all-out price war during the holidays. A hush descends as CEO Michael Glazer walks through the cafeteria and clambers onto one of the tables. Glazer's a playful guy who keeps an arcade racing game in his office. He's led KB for eight years and helped engineer the deal with Bain Capital that took the business private. But he's not smiling today.

1:30The employees brace for the inevitable. Morning, everybody. Last night, the board of directors decided we will apply for Chapter 11 bankruptcy protection. The news is greeted with sad silence. No one's surprised, but still, hearing it said aloud, stings. Glazer continues, We've had two miserable holidays back-to-back. This past December was brutal, the worst in my eight years here. But filing for Chapter 11 is a proactive and positive move. It worked for Kmart, and it can work for us. An employee near the front raises his hand. Are we going to lose our jobs? There will be headcount reductions here.

2:14We'll also close up to 500 stores. A ripple of concern sweeps through the room. We just have too many stores that aren't profitable, and we have to get out of those stores. However, these reductions aren't inevitable. If landlords reduce rents, the scale of closures and job losses could be much lower. But I know that we will emerge stronger from this. The employees want to believe him. But KB owes hundreds of millions of dollars to lenders, landlords, and suppliers. And then there's an even bigger problem. Its entire business model. KB's mall-based stores are saddled with high rents and long leases.

2:55Its shelves are packed with old toys sold at deep discounts, and new toys that cost more at KB than they do at Walmart or Toys R Us. It's a dated business model designed for the heyday of the mall. and there's no easy way to change it. And it's not the only toy retailer in trouble. After Walmart's vicious price war, Toys R Us is also shell-shocked and wondering whether it can reinvent itself before it's too late.

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5:32From Wondery, I'm David Brown and this is Business Wars.

6:22Toys R Us Incoming. Amazon. This is Episode 4, Tears Are Us.

6:37It's February 2004, and in Manhattan, Toy Fair's back. But this year, there's a cloud hanging over the annual showcase for the toy manufacturers. As delegates roam the exhibition hall checking out the latest inventions, the industry is also assessing the damage from the Great Toy War of 2004. And it's not pretty. KB Toys and FAO Schwartz are on life support. Countless independent stores are history. And even the mighty Toys R Us is bloodied. During the holidays, Toys R Us sales fell 5%. So it's trimming costs, shutting stores, and switching most of its staff to part-time employees. Walmart now owns 25 % of the toy market, far ahead of Toys R Us' 17%.

7:24But away from the exhibition floor, in hotel suites around the Flatiron District, toy makers are coming to Toys R Us' aid. In one suite, a sales rep from Mattel's Fisher-Price division is in deep conversation with a Toys R Us buyer. Bottom line is, we want to help. We're concerned about how Hokey Pokey Elmo got devalued last fall. We're a premium brand. Elmo's important to us. We don't want to repeat this Christmas. The Toys R Us buyer nods. Hokey Pokey Elmo spearheaded Walmart's barrage of discounts last year. Believe me, we'd rather have had Elmo on our shelves at$30. It doesn't need discounts to sell.

8:08We missed out on a lot of money from slashing the price, but we can't just sit around and do nothing when Walmart's discounting that hard. The Fisher Price sales rep leans closer. The thing is, we don't want a world where toys get devalued like that. And we don't want a situation where Walmart's the only game in town. So here's our offer. This year, Hokey Pokey Elmo is exclusive to Toys R Us. It's a shot in the arm for you and a chance for us to remind Walmart that Elmo's not going to be their loss leader. The Toys R Us buyer smiles. And Fisher Price isn't the only supplier coming to help. Hour after hour, toy makers big and small offer Toys R Us hot exclusives.

8:53None of them can afford to shun Walmart. But they all want to ensure Walmart's got competition. But even as the toy makers it once terrorized rally to save its stores, Toys R Us finds itself at war on another front.

9:13April 2004, Oakland, California. In a large meeting room in a law firm's office, the hope of reaching a consensus is fading. For nearly two days, executives from Toys R Us and Amazon have been clashing over the future of their online alliance. An Amazon executive reiterates the online retail giant's stance. We're simply allowing people to sell the toys you don't have on our site. What's the problem with that? The head of the Toys R Us delegation resists the urge to yell back. You know the problem. The problem is it's in violation of our strategic partnership. The contract is clear. We have exclusivity.

9:52We're paying$50 million a year to keep our competitors off Amazon.com, and you're letting them in. The contract has exceptions to the exclusivity terms, and we're using them because you are unable or unwilling to supply the level and range of product required under the contract. We stock thousands of different toys. Our goal is to be the everything store, and you don't offer everything. Then there's the issue of stock. You ran out of best-selling toys during the holidays last year, and that hurt our efforts to compete with Walmart. The two sides pause and eye each other from across the table. They hoped mediation would resolve the growing tension between them.

10:31But instead, it's made it crystal clear that the partnership deal they signed back in the year 2000 isn't working. The head of Toys R Us' delegation checks his watch and then rises from his chair. His team stands, too. He looks at the Amazon delegation. We're wasting our time here. You're in breach of contract, and unless you give us a reason to stay right now, we're walking out of here and filing a lawsuit. The Amazon team leans back in their chairs and crosses their arms. The Toys R Us team walks out. Twenty minutes later, Toys R Us files its lawsuit against Amazon. It wants unspecified damages or its money back and the right to walk away.

11:18A few weeks later, Amazon hits back with a countersuit, seeking damages from Toys R Us for not having an adequate supply of toys to meet demand.

11:31The breakup leaves Toys R Us fighting on two fronts. Online, it's duking it out with Amazon, the world's top e-retailer. And on the streets, it's locked in a life-or-death struggle with Walmart, the world's largest brick-and-mortar retailer. But in late 2004, Toys R Us enters the holiday season ready to fight. Its prices are competitive. It offers tempting combo deals and heavily touts the hot exclusives it's getting from toy manufacturers. But it's not enough. Sales slide again. And market share shrinks to 15%, low enough to raise the prospect of Target replacing Toys R Us as the number two toy seller.

12:16And customer satisfaction with Toys R Us is declining too, thanks to the store's new reliance on part-time staff. With sales sagging, the company's board of directors makes a shocking decision. It's going to explore selling its toy stores, so it can focus on its more profitable Babies R Us division instead. And in Boston, the news that Toys R Us is up for sale grabs the attention of the investment firm that used to control KB Toys, Bain Capital.

12:53March 16, 2005, Wayne, New Jersey. In the Toys R Us boardroom, the company's directors are working late. They've spent seven months soliciting bids for the toy store division. Now, the time to decide has come. CEO John Eiler picks up a whiteboard eraser and heads to the whiteboard. So Apollo's out because they only want Toys R Us and not Babies R Us? The directors nod. They've decided that the bidding is now high enough to justify selling Toys R Us and Babies R Us as a package. Eiler wipes Apollo off the board. There are now just two bidders left. The first is a consortium led by New York's Cerebrus Capital.

13:38The other is a consortium involving Bain Capital, KB Toys' largest stockholder. Eiler points to Cerebrus on the board. Let's start with Cerebrus. Their real estate is a big attraction for them. They were the first to seek to keep Toys R Us and Babies R Us together. They've offered$5.5 billion. That was at the high end of estimates. but Eiler points to Bain's consortium. Now that Bain's brought KKR in, their offer's risen to$6.6 billion. I think they're genuinely interested in running the toys business. One director throws out a question. Bain is the largest stockholder in KB Toys. Is a merger in the cards?

14:21I don't think so. KB's still in Chapter 11, and from what I understand, Bain will likely lose control of KB when the reorganization's completed. To me, the choice is clear. The Bain-KKR-Vornado bid is far higher. The only question I have, really, is do we postpone a decision and ask Cerebus to increase their offer? One director responds. Cerebus hasn't shown interest in increasing their bid. I just think Bain's the way to go. Eiler sees the rest of the board nodding. Okay, well, let's vote. All in favor of accepting the Bain, KKR, and Vernado offer, raise your hand. Well, that's a clear yes. The directors start to clear up their belongings, ready to head home.

15:09A few months later, the sale of Toys R Us is complete. The toy retailer is now a private company once again. But to get it, Bain, KKR, and Vernado have had to line up billions in loans. and those debts will weigh heavily on the company.

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17:09May 2005, Wilmington, Delaware. In a law office, attorneys from KB Toys and its creditors are finalizing a comeback plan. KB's been in Chapter 11 bankruptcy protection for almost 18 months. and now a way out of it looks possible. But the clock is ticking. Tomorrow is the deadline for KB and its creditors to provide the U.S. bankruptcy court with a plan to reorganize the company and take it out of Chapter 11. But if KB and its creditors can't agree on a joint plan, they will have to submit competing plans, leaving the future of KB uncertain. KB's attorney checks off another point of agreement. Ownership of KB will transfer at Apprentice Capital Management in exchange for$20 million cash and a$25 million credit line.

17:57The creditor's attorney nods. He represents the toy makers who are owed tens of millions by KB, including Hasbro, Mattel, and Lego. Agreed. But we want new leadership, not just new ownership. We believe that's reasonable given the financial management of the company prior to Chapter 11. KB's attorney knows what the creditors are getting at. Back in April 2002, KB's top executives and majority shareholder, Bain Capital, withdrew$121 million from the business. The creditors contend that move devastated KB's finances, leading to its bankruptcy. But Bain puts the blame squarely at the feet of the toy makers.

18:37It argues that the chain's financial crisis was caused by Walmart's aggressive price cuts. price cuts that were made possible by toy makers selling toys to Walmart at lower prices than KB was offered. But KB no longer wants to fight the toy manufacturers. It just wants a path forward. We can accept a change in CEO. The creditor's attorney smiles. The next day, KB and its creditors submit their joint plan to bring the chain out of bankruptcy. The core idea is that KB can hold its own by doing the opposite of the big box stores. Instead of offering rock-bottom prices and a bare-bones shopping experience, it will offer great customer service and attractive interactive displays that will make KB a go-to destination.

19:28Its goal is to be the most fun store in the mall, an experience, not just a shop. The court signs off on the plan, and on August 29, 2005, KB Toys exits Chapter 11. But it's a much leaner company now. Four years ago, KB had 1 ,300 stores. Now, just 650 remain. Thousands of staff are gone. It's sold off its eToys website, too. But even with the changes, many industry watchers doubt whether the future's bright for KB. But while KB looks forward to life after Bane, Bane's latest plaything, Toys R Us, is squaring up to face Amazon in court.

20:24September 2005. In the Superior Court in Patterson, New Jersey, Toys R Us' bearded attorney Michael Dockerman pulls out a Star Wars lightsaber. He stalks across the courtroom and jabs his lightsaber at the image of Amazon.com being projected on the screen. Here and here we see paid-for advertisements for toys being sold on Amazon's website by eToys. Dockerman turns to the man in the witness box, John Eiler, the former CEO of Toys R Us. Back in the year 2000, he led the toy retailer into its online partnership with Amazon. Mr. Eiler, is this a breach of the exclusivity Amazon promised Toys R Us?

21:07Eiler leans toward the microphone. Definitely. We would never have agreed to the deal if we weren't guaranteed to be the exclusive seller of toys and baby products on Amazon's website. So you agreed to set up shop inside Amazon's virtual mall, expecting to be the only seller of toys and baby products in the mall? Yes. Now, what did you do when Amazon began putting other toy sellers like Target and eToys into their virtual shopping mall? We objected strongly. Dockerman checks his notes and then resumes his questioning. You and Amazon CEO Jeff Bezos met in the summer of 2003 to discuss your concerns.

21:50Can you tell the court what happened in that meeting? We were informed that Amazon is introducing new technology to build a marketplace where small merchants can also sell toys. We felt this breached the exclusivity we were promised. Amazon tried to persuade us to relax the exclusivity terms of our partnership. We declined. So what happened next? Well, they introduced the technology anyway. That was when we concluded our differences were irreconcilable and sued to end the partnership. Dockerman lowers his lightsaber. But a few days later, he's back in the courtroom, ready to duel with Amazon CEO Jeff Bezos.

22:34Judge Margaret McVeigh watches Bezos sit down on the witness stand. I'm afraid the aircon isn't working today, Mr. Bezos. So you're literally in the hot seat. Bezos laughs and then readies for Toys R Us' attack. Dockerman brings up Amazon.com on the projector screen. Let's do a search for Brio train sets. Amazon's lawyer jumps up from his seat. Objection. This is expedient and unfair. Judge McVeigh glances at him. Overruled. Dockerman's assistant does the search. Dockerman points at the search results with his lightsaber. Here we see 60 results, including several from a rival seller called Trainsets Only.

23:16Now let's look at their Amazon-linked website. The assistant clicks on the link. Dockerman waves his lightsaber at the Trainsets Only page. Look, no results from competitors. Mr. Bezos, can you explain why Amazon lets Trainsets Only list its products exclusively while it puts results from competitors on its website for Toys R Us? Bezos leans toward the microphone. Our different feature sets are out of sync from time to time. Can you define the word competitor? Sure. Sometimes it's clear-cut, like Coke versus Pepsi. Other times it's more complex. Do books compete with going to the movies? I don't think of it that way, but they do compete for people's leisure time, so in that sense, they are competitors.

24:05Well, it seems to me that under your definition, sir, train sets only, does compete with Toys R Us. Your company promised Toys R Us that it would not allow competitors on Amazon.com. Yet, here's one. Can you explain why? We wouldn't have entered the deal with Toys R Us if we couldn't ensure a broad selection of products for our customers. We want to be free to use other merchants to sell the stuff that Toys R Us doesn't want to sell. Wanting to be free to do that, and being free to do that under this contract, are two different things. Now, when you met Mr. Eiler of Toys R Us in summer of 2003, you hoped to modify the exclusivity terms of that deal, didn't you?

24:48Yes. But no agreement was reached. Thus this trial. The courtroom joust between Toys R Us and Amazon continues for days. And it's Toys R Us that's racking up the points. The following March, Judge McVeigh delivers her verdict. She rules that Amazon violated its agreement with Toys R Us, didn't act in good faith with its promise of exclusivity to the toy retailer, and criticizes Bezos for his selective memory of events in court. She also frees Toys R Us from its deal with Amazon. And in July 2006, Toys R Us splits from Amazon and takes$100 million of sales with it. Amazon loses an appeal and eventually settles by paying Toys R Us$50 million in damages.

25:42But while it's lost Toys R Us' online business, Amazon is not about to quit toys. And as Amazon ups its play for online toy sales, Walmart gears up for another all-out assault on rival toy sellers. As the 2008 holidays begin, Walmart drops the equivalent of an atomic bomb on the competition by selling in-demand toys for just$10. It's a brutally low price, and both Toys R Us and KB Toys have little choice but to strain as hard as they can to match it. But no matter how hard they slash prices and profits to the bone, they can't get anywhere close to Walmart's$10 price tags. And for KB Toys, it's the final straw.

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