How eToys went from brilliant to bankrupt

But it had quintupled its customer base to 2 million, and had sold more toys than rival Toys R Us during the all-important holiday season.

"We believe our largest quarterly loss is behind us," founder and chief executive Toby Lenk wrote to shareholders last March.

Lenk turned out to be an optimist. The losses got bigger -- so much bigger, in fact, that they eventually drove eToys out of business.

The company said Monday it will file for bankruptcy protection within days. At the end of March its cash will run out, and shortly after that, the remaining employees will leave their Los Angeles headquarters for the last time.

So what went wrong?

"What they did right was create a wonderful brand name, increase sales at a phenomenal rate and become the premier online resource for people to buy toys," said T.K. MacKay, a stock analyst with Morningstar Inc.

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

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

Lenk declined to be interviewed by The Associated Press. Calls to three eToys board members who resigned last week were not immediately returned.

During its first holiday shopping season after going public, the site was swamped by orders, as were other online toy sites. eToys sold more than any of its competitors, but the publicity over late shipments dogged the company. Analysts say it also made customers wary of holiday Web shopping during the 2000 holiday season.

After the 1999 experience, eToys embarked on an ambitious and expensive plan to increase its capacity and expand its product offerings.

"They ramped up spending pretty aggressively," Williams said. "They could have run the business much more modestly. But when they made those decisions, it was a much different market than what it ended up being."

The change was marked by the dark days of March and April 2000, when Wall Street's no-questions-asked romance with tech companies was replaced by an impatient demands for profits. Funding for Internet companies dried up. Once-soaring stocks plummeted and dot-coms began announcing lower revenue and wider losses.

In the notoriously low-margin toy industry, competitors such as Toysmart.com, Toytime.com and Redrocket.com closed their doors. The shakeout left eToys and Toys R Us as the two largest competitors online.

Toys R Us made a smart move in late summer by partnering with Amazon.com -- Amazon would host the toyseller's Web operations and Toys R Us would provide the toys. The move allowed both companies to weather what few anticipated -- a slowing economy and weak holiday sales.

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

But the Christmas-time sales never came. Wary shoppers passed up virtual stores and instead visited other physical stores.

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

In January, the company laid off more than half its staff. In February, it sent layoff notices to its remaining workers and reiterated it had only enough cash to stay open until the end of March. Trading in eToys stock was halted Monday at 9 cents a share.

"In the end, it may just have been too small a market to pursue on the grand scale they did," Williams said. "Their management team was as good as it gets. The business model was just too aggressive and was going to take longer than they had."<