Is the retailer a victim of capricious regulators or its own bad management?

Conventional wisdom in the children's clothing biz is that moms skimp on outfits for themselves and their husbands 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 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 the shock to analysts earlier this month when Matthew McCauley, Gymboree's chairman and CEO, forecast a comparable-store sales plunge of 20 percent 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-based retailer off guard. The story of 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 profits.

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 LLC, an equity trading and research firm. "I have faith in this management team despite their recent blowup." Gymboree declined requests for comment.

The blowup stemmed from a perfect storm of events: a slowing economy, confusing regulations, and an overly hasty response from the company. When Congress passed the new 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, they 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, a huge burden for small businesses and thrift stores, many of which waited for further instructions.

Gymboree didn't waste any time. It launched an aggressive effort to test about 25,000 styles in the 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 are inaccessible to the child, Gymboree had already pulled otherwise acceptable products from its shelves and changed its production lines. "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." Clearly, investors would have preferred a wait-and-see approach.

Similar confusion happened with the phthalates ruling. On Nov. 17, 2008, the Consumer Product Safety Commission said the new phthalates levels would not apply retroactively to inventory. But it switched course on Feb. 5, five days before the regulations were to take effect, banning certain products regardless of when they were made. The change meant that 1.7 million Gymboree items couldn't be sold, causing the company to pull all sleepwear for kids ages 3 and under because of the plastic-coated feet. The impact from the two laws contributed to a $6 million write-off in the fourth quarter.