Still, the tainted-toy scandals have proven that outsourcing is fundamentally risky with toys, both because of the importance of quality control and the need to protect new ideas in an industry that constantly innovates. So Lego is now "insourcing" by building its own plant in Mexico and taking over the management of an outsourced plant in the Czech Republic. This earnest dedication to quality control has served Lego well: While most of its major rivals have dealt with product investigations and recalls, Lego's record is virtually spotless, and consumers haven't forgotten that, says Muller.
With its business fixed, Lego is diversifying again-cautiously, into games. In North America, however, it's the preschool market that's now the "strategic priority," says Laursen. For years, Lego has allowed Mega to dominate among the tots, doing little to push its large-brick Duplo brand into North America. Consequently, Duplo accounts for 14% of Lego's business in Europe but less than 4% in North America. Laursen concedes that, with Mega in financial trouble, it's a good time to attack the segment, but the market has always held appeal. After all, the lifetime value of a preschooler is much greater than a 10-year-old who'll soon graduate to video games. As well, preschool is a relatively stable segment, less given to fads, because mom and dad control the pocketbook.
Laursen claims his focus now isn't on battling for a few extra points of market share but rather on expanding the construction category overall. Outside North America, building toys make up 15% of the toy market; in Canada and the U.S., it's only about 4%. The category has been growing: While most toy segments dropped last year, sales of building sets surged by more than a quarter. Bertrand agrees that the main opportunity lies in pulling more kids and their parents into construction early, and he's betting Mega's price advantage will tap into consumers' current thrift. These days, 20 is the magic price band-whether dollars, pounds or euros. Any toys over $50 are tough sells.
Bertrand sees the economy as Mega's biggest challenge. Sales were down 14% last year from the previous year, with the biggest slide in the last quarter. "We have to be very smart in how we approach our product line and how we work with retailers," he says. "Retailers are going to be very cautious, from an inventory standpoint." Mega lost significant retail shelf space after the recall debacle, and may lose more as retailers worry whether it can pull through its difficulties. Muller says Wal-Mart and Toys R Us in the U.S. have been reducing shelf space devoted to Mega goods in recent months. He reports that Lego has "endcap" (end of aisle) displays in Target and Wal-Mart-prized by suppliers because they draw seven times the sales of regular shelves. He found no Mega endcaps.
Regaining retailer and consumer trust won't be easy. The Halo deal, announced in February, briefly revived Mega's share price, as investors were heartened that a player the size of Microsoft was willing to do business with the wounded toymaker. But there's a disconnect here: Halo, after all, is a violent game marketed to adults, not little boys; things have been toned down for the Mega-licensed Halo Wars, but only to the teenager level. Caron believes the line could reach around $40 million in sales in a few years, but it's not going to be a $200-million business like Lego's Star Wars line.
The Halo deal also won't make up for the loss of Disney, which accounted for half of Mega's licensed sales. Mega's big tie-in bets for this year are Nickelodeon preschool shows such as Wonder Pets! and Yo Gabba Gabba!-hardly household names. Observers believe Disney was unimpressed with how Mega was capitalizing on its brand. Two years ago, Mega put out a product based on Cars and had a hit with Pirates of the Caribbean toys. But licences for Iron Man (Marvel) and Transformers (Hasbro) went largely unexploited, which can't have escaped Disney's notice. Muller speculates that recall-singed retailers were reluctant to commit to new Mega lines, and without those commitments, Mega couldn't make the investment.
The 2008 results have started speculation about how long Mega can hold out. "There's always a chance it will survive, but the likelihood is not great," says Scotia Capital's Zicha. The answer may come as early as this summer, when retailers make their big holiday orders. As well, if Mega fails to maintain earnings and cash minimums through the second quarter ended June 30, its lenders can pull the plug.