Description

Red Envelope (ticker: REDE) represents an opportunity to buy a stock with rapidly increasing revenues, high gross margins, significant operating leverage and limited downside risk. REDE is an internet and catalog retailer specializing in gifts for all occasions. For 2005 (fiscal year ended April 3, 2005) the Company achieved revenue of $101.4 million and a net income loss of $5.2 million. The stock trades around $10 per share giving the Company a market capitalization of approximately $90 million and TEV of approximately $72 million (REDE has cash and short-term investments of $16.6 million and no debt). The Company’s stock currently trades at $4 below its September 2003 IPO price of $14. The goal of the Company is to become the consumer’s first choice for their gift giving needs by providing them with a fast and easy way to find the appropriate gift, a process that often becomes time consuming and frustrating. Its website, for example, allows buyers to search by occasion, recipient, category and price. The Company operates in the “affordable luxury” segment and the average order size for the holiday quarter in 3Q 2005 (the holiday quarter) was $87 (up 10%). A terrific Christmas was followed by a dismal Valentines Day quarter. The company’s gross margins contracted by nearly 1000 basis points and the stock came crashing down from $17 to its current levels. At $10, you have a security that is priced for a fairly bad outcome with substantial upside potential.

It is worth spending some time addressing the company’s Valentine’s Day stumble. The company had a relatively inexperienced CFO, who had not properly modeled the fully landed cost from its Asian sourced merchandise, specifically missing freight and duty costs. This had an affect on mix as the company promoted items that were not nearly as profitable as modeled. In addition, the mix has shifted away from US sourced goods to more Asian sourced goods. The company also had modeled a greater decline in bad debt, which did not occur. Finally, the Valentines Day catalogue did not generate a great customer response.

These problems have been addressed. The CFO was replaced buy the former CFO of Sundance Catalogues, Polly Boe, who has come with very good references. We have talked with her several times and are very impressed with her skills. The mother’s day and father’s day catalogues have been well received and the gross margins have returned to previous levels. The company has also hired a former senior vice president of marketing at Schwab to improve its customer loyalty and frequency of purchase through better data mining and a loyalty program – which should over time improve operating margins. This business at its heart is very similar to that of a credit card company such as Capital One. With each catalogue mailing it builds a larger customer base and over time that customer base buys more goods from the site if company continues to execute on the merchandising side. The company’s stock was probably punished in part because this was their second stumble in two years as a public company. The first mishap occurred when the company decided to in source warehousing and logistics right before the Christmas season, which resulted in high error rates for the crucial season. The company replaced the executive in charge and has had a smooth logistical operation ever since.

The Company’s sales grew 28% during Fiscal 2005 and this strong growth trend is continuing. The Company’s sales for the first quarter of FY 2006 have increased 18% versus FY 2005. The Company appears poised to grow its sales base substantially over the next few years. It would take a roughly 19% top line growth rate to double sales over the next four years, which seems possible given the past growth rate.

The trends for gross margin expansion are extremely favorable for REDE. From 2003 to 2005, gross margins have increased 420 basis points to 52.0% versus 47.8%. The Company’s ability to increase the proportion of both in-house designed products (58% for 3Q 05) and exclusive products (84% of the Company’s top sellers for 3Q 05) has driven this margin improvement. When the Company designs products itself it eliminates any royalty expense and is usually able to source products more cheaply than smaller vendors, resulting in margins that can be 10% to 20% better than third-party designed products. While the Company will never go to 100% proprietary designed products (not practical for certain products such as golf balls, Swiss army knives, and flowers), the proportion should keep increasing to a level of 75-80% of all sales. Exclusive products also allow the Company to charge higher prices while still offering compelling products to consumers. In addition, the company originally sourced many of its goods from smaller producers in California, but is now moving more of its sourcing to lower cost Asian manufacturers, which should increase margins. The Company’s average price per order has continued to increase and it has experienced the strongest growth in its higher priced categories. The most recent holiday season revealed that consumers are willing to pay up for luxury items as high end retailers faired better than those at the mid-range price level. Since the Company’s products are still at cheaper price points than many competitors, increasing average order price should continue to be a source of margin and revenue growth. The Company has put gross margins of 58% as its stated goal, but likely pricing and sourcing trends make even 60% attainable.

While REDE has grown sales to $100 million, the Company has the physical infrastructure in terms of distribution capacity, systems and personnel to support a Company with $300 million in sales. General & Administrative spending should substantially decline with higher sales volumes. The Company spent $18.1 million in 2005 on G&A to support $101 million in sales. G&A should not increase too much beyond $20 million even if sales grow to $200 million, a decline as a % of sales from 18% to 10%. Fulfillment spending, while partially variable, should decline due to greater capacity utilization from 15% of sales to 10% if sales doubled. The Company currently maintains distribution capacity far beyond its needs. While the Company has spent a large portion of its revenues on marketing (24% for 2005) and plans to continue to spend aggressively to build its brands, the larger $200 million sales base should allow marketing spending to fall to 20% of sales or slight below. These figures would imply an EBIT margin of approximately 20%. The table below summarizes what the margins for REDE could increase to if sales were to hit $200 million in 4 years:
2005 $200m Revenue in 4 years
Gross Margins 52% 60%
Fulfillment 15% 10%
G&A 18% 10%
Marketing 24% 20%
EBIT -5% 20%

If the Company can continue to grow its sales at a strong rate for the next few years and benefit from its operating leverage, REDE stock price could increase dramatically. With $40 million of EBIT the Company is potential worth $400 million at a 10x multiple or almost 5x its current market capitalization. Moreover, the company has approximately $75 million of NOLs that would allow it to shield income from taxes and aid in building a substantial cash position. The upside of the stock is very large, and none of this accounts for the market frenzy that can sometimes accrue to companies in the internet space.

While doubling sales is a lofty goal, a mere 20% increase in sales could yield substantial upside. Our estimate is that about 40% of that sales gain could and should drop to the bottom line, since they aren’t tax payers for a long time and have a large fixed overhead to leverage. The company would have broken even last year were it not for a $5mm brand campaign that appears to have little tangible sales benefit, and will not be repeated. Add in the $8mm that drops from a 20% increase in sales and you have about $8mm in net income or just under $1 per share. 10x that number plus cash is $12, 15x plus cash yields $17. None of these assumptions is heroic in terms of growth or multiple.

The downside for the stock appears fairly limited. The Company’s net cash position and potential as an acquisition target provide a margin of safety for investors. While the Company was plagued by operating difficulties following its IPO, these issues appear resolved. By spending aggressively and wisely on advertising, REDE has grown its customer file to 2.5 million and has substantially increased brand awareness. These assets have significant value to a potential acquirer. This year the Company will likely become EPS positive making an acquisition easier in terms of accretion / dilution for a buyer (even ignoring possible synergies in an acquisition). At a price of 1x projected 2006 revenues of $120 million (a reasonable valuation for catalog retailers) plus its cash, the Company is worth $14-15 per share to a buyer, giving no value to it NOLs. This valuation implies limited downside for investors at current levels. The value of its NOLs and cash alone is roughly $4 per share and the company has to date spent roughly $24 per share building its brand through marketing and advertising. There are obvious SGA and accounting synergies for any acquirer. At 50% of sales (a rock bottom valuation), plus the cash, you get roughly $8-9 a share. I think your downside is $1-2 dollars with potential huge upside if REDE performs operationally. In addition, the founder of the company has been agitating for management change, and eventually a sale of the company. It is my belief that should the company stumble again operationally, the founder, some board members and other large holders would push for a sale of the business. While you might not get the best price if the business were underperforming, it is hard to see much less than the current quote, which gives current investors a cheap call on the growth outcomes.

Catalyst

The optimal outcome is annual growth of close to 20% and a corresponding massive increase in operating income and eps. Should the company stumble operationally, I believe it will be sold for between $8 and $20 depending on how bad the stumble in the next 12 months. I believe, you get somewhere in the mid teens in a sale if an auction were held today.