Is Gymboree a victim of regulators or its own management?

Gymboree lost out by following new safety laws.
Gymboree lost out by following new safety laws. (By Victor Fisher -- Bloomberg News)
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By Kristina Dell
Sunday, March 29, 2009

Conventional wisdom in the children's clothing biz is that parents skimp on outfits for themselves before resorting to hand-me-downs for their kids. That's why Gymboree and other children's clothing retailers have been weathering the slowdown in consumer spending with surprising ease -- at least until now.

Gymboree, best known for outfits like girls' gingham butterfly dresses and princess snow drop jackets, logged 13 consecutive quarters of profitability and boasted record sales of $289 million in the fourth quarter of 2008. Its same-store sales dipped only 2 percent, a respectable showing in today's battered economy.

So imagine analysts' shock this month when Matthew McCauley, Gymboree's chairman and chief executive, forecast a comparable-store sales plunge of 20 to 25 percent for the first quarter of 2009 and continued woes in the second quarter during the company's recent earnings call. Accordingly, the company's stock dipped below $15 a share for the first time since 2005. While it's recovered somewhat, the question remains: Has the economy finally taken the bounce out of Gymboree?

Not exactly. The company attributes half the pain to two new federal safety regulations, which seem to have caught the San Francisco retailer off guard. Gymboree's fall is a cautionary tale about how trying to do the right thing can sometimes come back to bite your bottom line. Efforts to comply with laws passed by Congress that call for lower levels of lead and phthalates, a chemical found in plastics and screen prints, have toyed with Gymboree's profit.

What makes that claim curious is that most of Gymboree's competitors -- including Carter's and the Children's Place -- seem to be coping with regulations just fine. "Everyone was surprised because this is a company that has been executing and coming through the downturn relatively unscathed," says Linda Tsai, teen and children's specialty retail analyst at MKM Partners, an equity trading and research firm. Gymboree declined to comment.

The blowup stemmed from a convergence of events: a slowing economy, confusing regulations and an overly hasty company response. When Congress passed the Consumer Product Safety Improvement Act in August 2008 on the heels of the 2007 lead scare that forced a recall of tainted toys made in China, it intended to limit lead levels in all kinds of goods aimed at children 12 and under -- everything from toys to books to clothing. All untested merchandise had to be off the shelves by February.

Gymboree didn't waste any time. It launched an aggressive effort to test about 25,000 products in its 800-plus stores and remove any embellishments like rhinestones, metal zippers, snaps, buttons and grommets that didn't meet the new limits before the Feb. 10, 2009, deadline. When a clarification to the lead law came out four days before the deadline, making it more lenient on embellishments that children can't reach, Gymboree had already pulled otherwise acceptable products from its shelves.

"Being conservative hurt them, unfortunately," says Thomas Filandro, senior equity analyst at Susquehanna Financial Group, a financial firm. "But the risk of not being conservative and getting caught with product that consumers believed was harmful to children far outweighed the risk of being off the mark in the spring season."

Similar confusion occurred with the phthalates ruling. The impact from the two laws contributed to a $6 million write-off in the fourth quarter.

But why is Gymboree suffering such heavy losses while most of its competitors -- such as the Children's Place and Baby Gap -- have emerged intact? During the March 4 earnings call, McCauley gave his explanation: "[The regulation] is a much bigger impact to our business than perhaps it will be to others mainly because of the outfit nature of our business. . . . Girl [clothing] is such a large percentage of our business, and we took a very cautious interpretation of the law."

Still, customers can't help but notice that the glitter is gone at Gymboree. After pulling products and reworking styles, many of the remaining pieces lack the bling that Gymboree is known for and for which it can charge a higher price than competitors. Some of the merchandise that survived often had no mate and had to be marked down. For instance, moms might not have been able to find the matching top or purse that went along with detailed pants.

It's still hard to ignore that Gymboree's competitors seem to have taken the regulation confusion in stride. "We addressed the regulations in the fourth quarter and moved on," a Gap spokeswoman says. "We weren't caught off guard because the rulings happened in 2008."

Even so, Filandro gives the company's management team high marks for creativity and operations. "In the short run, their approach is clearly an issue, but it would have been worse if it hadn't done anything and got caught," he says. "They will get through this." With the new collections set to hit stores in May, customers will determine just how long a turnaround will take.


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