Description

Red Envelope (“REDE”) currently trades at 0.33x sales, has a total enterprise value of ~$35m, $10m in cash and no debt. We are recommending the purchase of REDE shares ahead of a potential turnaround this holiday season. The company is under the direction of their third management team in as many years, and we believe this one, led by Executive Chairman John Pound, is finally set to realize the potential of the brand. The shares have traded off to $5 ahead of what are expected to be poor results for the September quarter, but we believe investors are missing the forest for the trees. The September quarter is the least important of the year due to the lack of any material holidays, and includes a ramp in working capital as the company builds inventory ahead of the Christmas selling season. Since Pound formally took the reigns in April, he has been able to change out 25% of the merchandise, but more importantly, has begun to reinvent the Red Envelope image. The catalog and website have been relaunched for the holidays with a look and feel much more akin to Pottery Barn, versus prior looks reminiscent of an old Service Merchandise or Sears catalog. In addition to bringing in new merchandise, including deeper selections in the most popular lines, management has continued to work through a significant amount of slow moving inventory.

REDE was written up before on VIC in 2005, when the company was still under the direction of Allison May. Please refer to the write-up by bedrock346 for further background on the company. Shortly after this posting, Allison May was replaced as CEO by Ken Constable, a veteran of Dell and more recently SVP and general manager of ProFlowers, which was sold to Liberty under his watch at a substantial premium. Ken was brought in by the board to fix the bloated cost structure and finally make the business profitable. His priority for fiscal 2007 (year ended March 2007) was to be free cash flow positive for the first time. Upon hiring Ken, several well regarded hedge funds, as well as current Chairman John Pound, bought substantial stakes in REDE (amounting to a substantial majority of the shares), and things had finally appeared to turn the corner. The stock initially faded from $10 down to $6.50, but built support back at the $8 level following a strong fiscal third quarter, which reflects Christmas holiday sales. Unfortunately for investors at the time, this was the highest valuation they would see, and Ken was dismissed in April by the Board. While Ken was successful in his pursuit of profitability, the Board discovered that it came at the expense of new customer prospecting. By focusing on maximizing sales to current customers, Ken was able to meet the profit goals the Board had laid out for him, but it was to the detriment to future growth.

The lack of prospecting has led to three straight quarters of year over year reductions in new customer growth. But under the current leadership of John Pound, we believe these negative trends will turn positive in 2008, with a good chance that holiday 2007 sales will also come in ahead of massively lowered expectations. As a lack of new customer prospecting has negatively affected current sales, the resumption of prospecting this summer should drive increased customer acquisition in 2008. However, even without new customers, REDE should be able to win greater repeat business from their current active customer list through their ongoing shift away from a “tired product assortment” (Pound’s quote from first earnings release) towards more inspiring products, such as the ballpark cuff links (see website www.redenvelope.com).

Unfortunately, as over 75% of REDE’s products are internally designed and sourced from overseas manufacturers, the lead times average 6-9 months for most new merchandise. We would have loved for Pound to come in and turn the merchandising on its head and have a 100% new lineup heading into holiday 2007 – but with the lead times involved, he was only able to put his personal stamp on around 25% of the current holiday catalog. But it is the new creative message evident in the latest holiday catalog that may offset the other negatives heading into this season. We urge potential investors to look at the latest catalog on their website and judge for themselves. No matter one’s personal reaction to the current state of the creative, there can be no argument that it is a tremendous leap from where REDE was a year ago, when the catalog was simply a listing of products names, pictures and prices.

So as we stand, calendar 2008 (fiscal 2009) will feature a continuing shift away from legacy merchandise, a more refined creative message to customers, and the rewards from renewed 2H2007 new customer prospecting initiatives. Additionally, Pound has spent several million dollars this year to overhaul the fulfillment center and implement new software initiatives to gather and analyze customer data to create a more targeted marketing message. These latter two projects are not readily visible to the end consumer per se, but will contribute just as much, if not more, to future growth.

At this point, you may be asking who John Pound is and where did he come from? His bio can be found on his fund’s website, www.integrity-brands.com. He is a well-regarded investor focused mainly on the specialty retail industry, with past success found in the likes of Gymboree, Cache and United Retail Group. He was brought onto the board by company founder Scott Galloway and was named Chairman a couple of months prior to the departure of CEO Ken Constable, at which time he was named Executive Chairman of REDE. Pound is very much aligned with shareholder interests with a 9% stake in the company, and has also personally arranged for $2.6m in bridge financing for the current holiday season should the company require additional working capital heading into December. He has a fantastic track record at similarly troubled branded companies, has shown he is willing to put his money at risk alongside shareholders and is obviously shown himself to be an active, hands-on investor. He took over control of the company at a difficult time of year to enact near-term change, but given enough time to repeat his prior successes, John Pound should be able to reap rewards for all shareholders in Red Envelope.

Valuation:

At $5, REDE stock is currently trading around 33% of sales, with a market cap of $47m, 10m of cash and no debt. At the low end of peer valuations, retail companies facing financial crisis tend to trade in a range of 15-25% of sales, with SHRP the best current example of where shares could go if the company does not gain traction in the coming months. On the flip side, growing brands with at or on the verge of profitability tend to trade over 1x sales, such as AMZN, OSTK, IACI, FTD and PETS. Refer to the table below for current peer valuations:

From the table below, one can see that near-term downside risk to shares due to lower than expected holiday 2007 sales is around $3, with substantial upside should Pound right the course of the company.

Possible Takeout?

Provide Commerce, and online retailer of flowers of and gifts, was sold to Liberty in early 2006 for 2.5x sales, which opens the door to questions on takeout probability for REDE. The company had hired Hambrecht early in 2006 to pursue strategic alternatives. While we don’t know what sort of prices were offered, we can only surmise that REDE received bids at or above the $8 price at which John Pound bought his stake, with full knowledge of such activity due to his Board membership at the time. We believe the obvious suitors are any company with an online retail presence. The synergies involved in combining marketing and fulfillment operations together with a sharing of customer lists would justify a substantial premium to the current share price by the likes of LINTA, IACI, FTD, FLWS or even the book stores.

Catalyst