A May 31 Washington Business article incorrectly said that Wal-Mart earns a profit of $6.77 on a Kid Connection light-and-sound robot manufactured in China. That figure represents the difference between what the chain was charging for the toy in an Oklahoma City store and the cost to manufacture it, but it does not account for expenses such as shipping and distribution. (Published 6/8/04)

In 1997, Tree Top Toys Inc., an independent retailer with stores in the District and McLean, began carrying a nifty children's toy called Chunky Farm. At $32, the collection of large plastic farm items, including a barn, a rig and a cow, sold briskly and earned Tree Top a nice profit because each cost Tree Top only $16.

About 18 months ago, however, the store dropped Chunky Farm from its lineup, not because it sold poorly but because it had suddenly begun flying off the shelves at a nearby Wal-Mart. Tree Top's toy buyer spotted it there for about $14.

"I can't compete with that," said the buyer, Susan Hancuff-Sellers.

When it comes to Wal-Mart Stores Inc., the toy industry is learning how to play by a painful new set of rules. Analysts estimate that Wal-Mart now controls at least 22 percent of the U.S. toy market, meaning one out of every five toy purchases occurs at its stores. With more than 3,000 stores, the giant discounter is three times the size of Toys R Us and is bigger than all of the nation's independent toy stores combined, according to the American Specialty Toy Retailing Association, a trade group.

Because it wields vast buying power, Wal-Mart's decisions reverberate throughout the toy market. Even in the Washington region, where the Bentonville, Ark.-based chain has 14 Wal-Marts and six Sam's Club stores, all of them outside the Capital Beltway, its practices influence prices, what retailers carry and what stores are around town.

This year two toy chains, FAO Schwartz Inc. and KB Toys Inc., filed for Chapter 11 bankruptcy protection from their creditors. A third, Toys R Us Inc., said it would sell 146 of its Kids R Us children's clothing stores and 35 Imaginarium stores, which offer educational toys. Analysts say fierce price competition from Wal-Mart was the chief reason.

Less understood is Wal-Mart's impact on smaller retailers such as Tree Top, which appeal to wealthier customers who do not necessarily make purchases based on price. It is those stores that take big gambles on new toys, only to see them snatched up by Wal-Mart.

Tree Top, the flagship store of which is in Foxhall Square in Northwest Washington, opened 25 years ago. The two stores, which together have about 40 employees, carry about 10,000 products, most of them from small manufacturers that favor independent toy stores, said Susie Waterstreet, who manages Tree Top's District store.

Inside, the store's narrow aisles are crammed with high-end train sets, dolls and books. There are Groovy Girls, a line of dolls with matching accessories. There is a Thomas & Friends Circus Train, a three-car set made of wood and plastic. And there is Pretend and Play's Teaching Cash Register, with a built-in coin identifier.

There is no Barbie, Hokey Pokey Elmo or Monopoly, three of the industry's best-selling toys. There are no realistic-looking guns, no blood-spattering video games or weapon-wielding military action figures. "We want toys that spark the imagination," Waterstreet said.

But even here, employees studiously examine what toys are in Wal-Mart and, whenever possible, avoid overlap. If Wal-Mart prices are too low, it will make Tree Top prices seem too high.

Thus it dropped Chunky Farms after Hancuff-Sellers discovered its drastically reduced price at a local Wal-Mart. "It can be really bad for business," Hancuff-Sellers said.

Chunky Farm's manufacturer, Shelcore Inc., said it has no control over what Tree Top or Wal-Mart charge for its toys. Suggested retail prices are just that, said Deke Jamieson, vice president of marketing for the Somerset, N.J., company.

When Tree Top employees believe the stores must keep a more expensive product on the shelves, they often cut back on quantity, leaving just enough inventory to satisfy demand. At the store in McLean, the LeapPad Learning System, a popular electronic reading tool, sells for $54.95, compared with $33.24 at the nearest Wal-Mart, in Alexandria. Lego's Spider-Man: The Final Showdown is $59.95, compared with $48 at Wal-Mart (and as low as $24 on clearance).

Deep Discounts

Wal-Mart was not always king of toyland.

The discounter surpassed Toys R Us as the No. 1 toy seller in the late 1990s with an aggressive push into action figures, dolls and video games, said Howard L. Davidowitz, chairman of Davidowitz & Associates Inc., a national retail consultant and investment banking firm in New York. He estimated that the chain now controls 27 percent of the toy market.

Because of its size, Wal-Mart has the flexibility to break even or even lose money on toys, making up the revenue with sales in other departments. The tactic builds customer loyalty and helps steals market share from competitors, said Jim Silver, publisher of ToyBook, a trade publication.

That, toy analysts say, is what happened last Christmas. At Wal-Mart, the season's hottest toy, Hokey Pokey Elmo, sold for $19.46. KB Toys paid $24 for the same toy, and charged $24.99. At the time, KB Toy spokesman, John Reilly, said such pricing amounted to "giving away toys."

Karen Burk, a Wal-Mart spokeswoman, would not comment on the chain's pricing strategies, which she called "competitor-sensitive." She said toys "were a very profitable category this holiday season."

While it slashes costs on some toys, Wal-Mart earns a substantial profit on others, according to a toy executive who has sold products to the chain for 10 years. To save money, Wal-Mart contracts with manufacturers to make several private label toys, which are sold under names such as Wal-Mart's Kid Connection. Profit margins on these products, many of which are manufactured outside the United States, are often twice those of brand-name toys, said the executive, who spoke on condition of anonymity because he continues to do business with the retailer.

For example, a Kid Connection light and sound robot with matching action figures and helicopter cost $3.11 to manufacture in China, said the toy executive, who has visited the factory in Shenzhen where it was made. Last week, it cost $9.88 at an Oklahoma City Wal-Mart Supercenter, giving the chain a profit of $6.77 per toy.

Wal-Mart declined to comment on private-label pricing.

Wal-Mart also commands deep discounts from toy manufacturers because it orders such large quantities of toys. "I have a price sheet for Wal-Mart and a price sheet for everyone else," said the same toy executive.

Under federal law, such discounts are legal if a toymaker can show it saves more money by selling to Wal-Mart than to its competitors, said Joseph P. Bauer, a professor of law at Notre Dame Law School. The more toys Wal-Mart buys, the more discounts it can demand from a manufacturer, he said.

Money in Mass Marketing

This leaves manufacturers in a dilemma. They like being in the small specialty toy stores but the big money is made in mass marketing.

"I don't think you can have very much success by selling to 3,000 independent toy stores," said Matt Brown, co-founder and president of Big Boing LLC, a small toymaker in Sausalito, Calif.

But manufacturers who take their toys from specialty stores into Wal-Mart face some risks. In 1994, Hands on Toys Inc., a small toymaker in Wilmington, Mass., launched Toobers & Zots, a foam construction kit, in the specialty store market. It was an overnight success, earning the company $4 million in its first year, the company's president, Andy Farrar, said.

Hands on Toys declined an offer from Sam's Club, a unit of Wal-Mart, to stock its products. Soon after, Farrar said, Sam's Club introduced a line of toys strikingly similar to Toobers & Zots, which began eating into his sales. To regain ground, Farrar licensed the toy to Hasbro, one of the nation's biggest toymakers, which in turn sold it to Wal-Mart and Target Inc.

In response, hundreds of independent toy stores across the country canceled their orders. "People felt that we had betrayed them," Farrar said. "They were screaming at me at toy conferences." To this day, he said, some independent toy stores will not carry his products.

To avoid such a pitfall, Lights, Camera, Interaction Inc., a toymaker in Westport, Conn., reserves some toys for independent stores and others for national chains. "We have products these larger stores will never see," said Rick Davis, the company's marketing director.

Small-Shop Specialties

Independent stores are not totally powerless, as Hands on Toys and Shelcore found out. When toy manufacturers decide to sell to the big chains, small stores quickly dumped their products.

Independent stores are finding other ways to compete. Earlier this year, Jeff Franklin, the owner of Be Beep A Toy in Annapolis, hired a therapist to teach his staff of 10 about the developmental benefits of play, hoping to give them an edge over their big-box counterparts. "You cannot find that kind of training at Wal-Mart," he said.

At Tree Top, employees invite representatives from toy manufacturers to teach children how to use their toys. They hold book readings. They stage themed events, such as a Harry Potter Day, in which the store staff dress up as characters from the book. And to help first-time gift-givers, they have drawn up toy guides, each based on a child's age.

Davidowitz said independent stores will succeed only by outperforming the chains where they are weakest: product selection and service.

"They can't compete on price but they can compete on the overall shopping experience," he said. "The Wal-Mart shopping experience is not so good. If you go to one of these Wal-Mart Supercenters, the store is a zoo. It is not fun shopping at a zoo."

Eli Waldman is surrounded by hundreds of toys at Tree Top Toys in McLean. Independent retailers such as Tree Top find it difficult to compete with Wal-Mart, which analysts say controls at least 22 percent of the toy market.A young shopper looks over the toys at a Wal-Mart in Plano, Tex. Wal-Mart wields enormous power in the toy market.June Wannan of Tree Top Toys in McLean, right, helps Kiki Vargas pick a gift.