When trying to determine how Mattel Inc. could fall so far so fast, all roads point to the deal with the Learning Co., creator of titles like "Reader Rabbit" and "Carmen Sandiego."

Just two months after Mattel acquired the software developer in a long-delayed bid to diversify its product line, the El Segundo-based toy maker reported a $345 million charge against second-quarter earnings.

On Oct. 4, Mattel said earnings would be at least 40 percent short of estimates, due to Learning Co. losses, which later were reported to be $105 million.

The next month, the Learning Co. president resigned.

And earlier this month, Mattel reported that Learning Co. suffered a $183 million net loss for the fourth quarter leading to the abrupt resignation of Mattel Chief Executive Jill Barad.

All these events beg an obvious question: Didn't Mattel realize they were buying into one turkey of a company?

Mattel officials declined to comment about any aspect of the acquisition. But toy-industry analysts and others say that what happened represents a nightmarish scenario for an established industry giant trying to catch up too far, too quickly.

Certainly, some of what happened in the last years could be attributed to poor timing or simple bad luck. Several of the Learning Co.'s "edutainment" products, for example, unexpectedly fell out of favor with a fickle public.

But beyond happenstance was something far more fundamental: due diligence.

"Jill and her management team were so desperate to get some dot-com pixie dust that they were willing to look the other way," said one analyst. "They had every opportunity to examine the inner bowels of TLC."

The irony is that Mattel did well in other places, starting with the stalwart Barbie division, which saw a 5 percent sales increase last year, to nearly $1.9 billion. Its Fisher-Price subsidiary had a 48 percent increase in sales in 1999 and Hot Wheels posted a 15 percent increase for the year.

"Were it not for the Learning Co., we probably wouldn't be having this conversation today, because other divisions performed strongly," said David Leibowitz, an analyst at Burnham Securities in New York.

Litany of problems

Why did Mattel go after the Learning Co. in the first place? For all the success with Barbie, the company had lacked a successful interactive division, as well as a popular software game. And since boys remain the typical players of video games, having a bevy of Barbie titles didn't appeal very much to that target market.

The Learning Co. purchase was hailed as the answer. But a further examination by Mattel would have revealed a multitude of troubles.

-While the Learning Co. was one of the largest "edutainment" software producers in the nation, it achieved that market share through a series of not-so-sound acquisitions. Beginning in 1995, the company spent almost $1 billion on acquiring other, smaller software companies. This practice left the parent company bigger, but not necessarily better it was laden with hundreds of millions of dollars in acquisition-related debt and a bunch of disparate divisions.

"You lost a lot in the merger of these companies," said Lewis Alton, managing partner of L. H. Alton & Co., an investment bank. "It's like throwing Apaches and Cherokees together. Just because they're a bunch of Indians doesn't mean they want to pull together and assimilate."

-When assessing the acquisition, Mattel was working with off-target advice from Goldman, Sachs & Co., according to several sources. "Whoever advised the purchase was woefully uneducated about the industry," Alton said.

Goldman, Sachs whose officials did not return phone calls last week valued the cash flow of the Learning Co. at between $3.2 billion and $6.2 billion. Since being acquired by Mattel, the Learning Co. operation has lost in excess of $200 million, and Mattel expects to spend another $75 million to $100 million to restructure the operation.

-There was a well-documented history of concerns about the Learning Co.'s accounting procedures. In August 1998, the proposed acquisition of San Rafael-based Broderbund Software Inc. almost fell through when Pacific Crest Securities analyst Jeff Goverman questioned the way the Learning Co. had handled its accounts receivables. Other analysts released reports expressing similar concerns.

"What happens when you record revenues before you should is, you're stealing future revenues and jeopardizing future earnings," said Sirine Hafez, an analyst at Center for Financial Research & Analysis Inc., who covered the Learning Co. "That's a big concern because you're playing around with numbers."

-The software successes of the Learning Co. were titles like "Reader Rabbit" and "Carmen Sandiego" titles that Mattel thought would become enduring favorites. But they fell out of favor in comparison to newer lines like Hasbro Inc.'s Pokeman and titles by Nintendo.

"I don't know if the Learning Co. was pulling the wool over Mattel's eyes, per se, but I think it was more of a matter of them giving Mattel what Mattel wanted to see," said Howard Dyckovsky, an analyst with PC Data. "Both companies have (PC Data sales figures) on what's selling in the marketplace and how much inventory is out there. It shouldn't have been too hard to find out from the Learning Co. what they had in development. But (maybe) no one from Mattel bothered to look."

Heads roll

All this turmoil has caused management upheaval at the El Segundo-based Mattel. In November, amid mounting pressure, the two founders of the Learning Co., Michael Perik and Kevin O'Leary, resigned a month after news of the interactive division's troubles became public. In January, the company appointed Bernard Stolar, a former executive with Sega of America Inc., to head up its interactive division, which includes the Learning Co.

Last week, it was announced that Kevin Farr would replace retiring Chief Financial Officer Harry Pearce. Farr, who has been with Mattel for eight years, was senior vice president and corporate controller of the company.

Of course, the first step in Mattel righting itself involves cleaning up the Learning Co.

"Something radical needs to be done and quickly, whether it means hacking off parts of the company or putting a SWAT team in to fix it," said M. Eric Johnson, professor of management at Dartmouth College, who follows the toy industry.

"The key is digging further into how the Learning Co. works. Jill (Barad) indicated surprise at the level of returns that were showing up from Learning Co. software products, which means she didn't understand the software industry. With toys, you sell them to the retailers and you don't get them back. With software and CD-ROMs, there are more channels of distribution where you expect returns. It seems that Mattel didn't understand that," he said.

Ultimately, nothing works better to turn around a flagging product line than to create a popular new product.

"This is a product/title-driven market," said Jim Silver, publisher of trade journal Toy Book. "Look at the success of 'Reader Rabbit' and 'Myst.' The thing is, those peaked two years ago and they need to develop something hot. It may be tough to attract lucrative licensing agreements since Learning Co. doesn't have the positive brand awareness as other heavyweights. But, Mattel has proven that it has the marketing muscle to ink significant partnerships."

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