Through much of the 1980s and '90s, Lego averaged 10% annual sales growth, far exceeding the industry rate. By 1992, the private company held 80% of the global construction-toy market. Eager to capitalize on consumer loyalty, Lego expanded into theme parks, clothing lines, movies and books. But the company neglected the changing needs of its core consumers-boys aged 5 to 9-who were increasingly opting for toys linked to hit movies, comic books and cartoons. The trend toward video games also hurt. The misreading of the market, combined with bad investments, conspired to produce a $350-million loss in 2004, dangerously low cash reserves and the risk of bankruptcy.
During Lego's decades-long hegemony, many tried to muscle in on its terrain. Lego's lawyers fought back, but by the late '70s, the company's major patent had expired and it was increasingly losing in court. And in the mid-'80s, a Montreal toy distributor named Victor Bertrand saw an opening in Lego's flank.
A toy salesman from the age of 17, Bertrand was manufacturing his own plastic toys by his early 20s and soon built one of Canada's biggest toy distribution businesses. But he wanted a larger playing field. Lego's large-block Duplo line had little uptake in North America, so Bertrand created his own version of snap-together bricks for toddlers and preschoolers. The bright-coloured, low-priced Mega Bloks took off immediately. By the late '80s, they were selling in 30 countries.
Mega's blocks were initially bigger than any Lego made, but in time grew to closely resemble Lego's products-so much so that kids could snap pieces from the two lines together. In 1996, Lego filed a trademark-infringement lawsuit, claiming that the shape of its bricks was legally protected intellectual property. The Canadian judge's demurral didn't deter Lego, already infamous among rivals for its litigiousness. It has been dragging Mega through courts around the world ever since. (The latest skirmish, an appeal in European Union courts last November, was the 15th time in a row Mega has prevailed.)
Seen by North American retailers as a homegrown underdog to a foreign monopolist, Mega won acres of shelf space for its cheaper alternatives. "The Bertrand brothers had very good relations with the retail community. A lot of vendors don't," says Jim Silver, editor-in-chief of ANB Media, a publisher of toy-industry publications. "They were seen as honest and fair." Through the mid-'90s, Mega's sales were surging by around 70% a year, growing even when the rest of the category was down. By 2006, Mega controlled roughly half of Canada's construction-toy market, supported by such valuable licences as Dora the Explorer, Spider-Man and Disney's various properties.
With Mega's share price zooming-it topped $20 (Canadian) in 2004-the Bertrands decided it was time to diversify, and looked toward the arts-and-crafts sector, in part to make inroads with girls. As it happened, New Jersey-based Rose Art Industries, the second-biggest player in that segment, was run by another two-brother team that had taken over from their father. Aside from colour-in posters and activity kits, Lawrence and Jeffrey Rosen also boasted a hit line of magnetic construction toys, Magnetix. Here was Mega's chance to expand beyond the brick. In the summer of 2005, Mega bought Rose Art for $350 million, amid much celebration of the companies' similar roots and family loyalties. Rose Art was bigger than Mega, and most of its products retailed through channels with which Mega had no experience, but investors applauded, giving Mega's shares their biggest single-day jump to that point.
Despite the soaring stock, the deal was financed largely with debt, which made it risky. "There wasn't much margin of safety if something went wrong," says an analyst who followed the company at the time. Mega previously had virtually no debt, and had never made an acquisition. "In terms of building and operating a toy company, it's hard to rate [the Bertrands]any lower than 8.5 out of 10," says Benoit Caron, an analyst with National Bank Financial who covered Mega until recently. "In terms of the Rose Art deal, it's 4 out of 10. Everything that could go wrong with that acquisition, went wrong."
Perhaps the first hint of trouble in toyland was the two fraternal duos' different approaches to business. "It was a poor blend of personalities, like mixing oil and water," says ANB Media's Jim Silver. Another observer puts the polarity more vividly: "It was like putting a cat and a mouse into a cage."