Item 1.
Business
This Annual Report on Form 10-K and the documents incorporated herein by reference contain forward-looking statements based on expectations, estimates and projections as of the date of this filing. Actual results may differ materially from those expressed in forward-looking statements. See Item 7 of Part II - “Management’s Discussion and Analysis of Financial Condition and Results of Operations - Forward-Looking Statements.”
Overview
RedEnvelope is a branded online retailer of upscale gifts, dedicated to helping its predominantly female customers celebrate and nurture their most important relationships with unique gifts and unequalled gift-giving experiences. RedEnvelope offers an extensive and fresh collection of imaginative and original gifts through our catalog, web store and phone store. We strive to maintain the highest standards for product distinctiveness, quality and value, gift delivery, gift presentation and customer service, in an effort to provide our customers and their recipients with the best possible gift giving experience. We believe this provides the foundation of our repeat business. We have developed an internal database of approximately 2.9 million customer names, with approximately 574,000 new customers added in fiscal 2006.
We strive to offer a wide assortment of quality, thoughtful gifts, many of which are difficult to find elsewhere and are not easily replicated. Our in-house design team creates unique proprietary products, and our merchants source products domestically and from various parts of the world, often commissioning artists and vendors to create exclusive gifts. Our gift wrap is distinctive and closely associated with our brand. Gift-wrapped products are delivered to the recipient in a branded, high-quality red box with a hand-tied ivory ribbon. We offer a wide assortment of products in fourteen categories with the majority of products ranging in price up to $150. Our core product categories include jewelry, home, men’s and women’s accessories and new baby gifts.
Through our web store, www.redenvelope.com, customers can search for gifts by occasion, recipient, product category and price point. Our web store generally features approximately 700 to 750 products, increasing to over 800 products during the holiday shopping season. In addition, through our web store, our customers can register for our gift reminder service, sign up to receive email promotions, view their order history, chat live with a customer service representative and request a catalog. In fiscal 2006, approximately 80% of customer orders were placed through our web store with the remainder placed through our phone store. We also publish our full-color catalog several times during the year. Each catalog generally features approximately 130 products, increasing to approximately 235 products during the holiday shopping season. The catalog also serves as the primary direct marketing channel and advertising vehicle for our web store and phone store. During fiscal 2006 and 2005, we mailed approximately 30.8 million and 25.8 million catalogs, respectively. We also sell directly to corporate clients through our Business Gift Services (“BGS”) group. BGS leverages our existing merchandise assortment to help businesses with their holiday giving, as well as other corporate gifting needs during the year.
We currently intend to focus on the following strategies:
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Focus our strategic attention on the relationship-building essence of gift-giving - by better understanding our customers’ relationships and recipients, and by providing gifts, gift reminders and gift services that help them celebrate their closest personal relationships
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Simplify our business - by concentrating on our core female customers, their core relationships and recipients, their most important recurring gift giving occasions, and the core product categories we believe they prefer for celebrating these occasions with their inner circle family and friends
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Execute with excellence - by implementing a more disciplined approach to financial and operations management, including tight cost controls and inventory management
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Improve marketing efficiency - by increasing our focus on generating repeat purchases from existing customers through increased relevance and increasing the efficiency of our customer acquisition efforts
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Continue distinctive product innovation - by continuing to refresh our product offering each season
RedEnvelope, Inc. was incorporated in California in June 1997 under the name “Giftworks Online, Inc.” and changed its name to “911 Gifts, Inc.” in December 1997. We reincorporated in the State of Delaware under the name “911 Gifts, Inc.” in March 1999 and changed our name to “RedEnvelope, Inc.” in September 1999. We made an election to be treated as an S Corporation for federal and state tax purposes, which remained in effect through February 28, 1999, the day prior to our reincorporation in the State of Delaware. We completed our initial public offering in September 2003, and our common stock is listed on the Nasdaq National Market System under the symbol “REDE.”
Recent Events
On May 16, 2006, we announced that the Company has engaged WR Hambrecht & Co as our financial advisor to assist in exploring strategic alternatives to maximize stockholder value, including, but not limited to, the possible sale to, or merger of the business with, another entity offering strategic opportunities for growth. However, there can be no assurances that the exploration of strategic alternatives will result in a transaction. For a discussion of these and other risks, see “Item 1A
Item 1A.
Risk Factors
You should consider carefully the risks and uncertainties relating to our business including those described below, together with all of the other information included or incorporated by reference in this Annual Report on Form 10-K. Additional risks and uncertainties not currently known to us or that we currently do not deem material could also become important factors that may harm our business. The trading price of our common stock could decline due to any of these risks and uncertainties, and you could lose all or part of your investment.
Our limited operating history makes evaluation of our business difficult.
We were originally incorporated in 1997 and began selling products in September 1997; however, the Company has grown significantly in size and complexity since its inception. As a result, we have limited historical financial data upon which to base planned operating expenses or forecast accurately our future operating results. Further, our limited operating history will make it difficult for investors and securities
analysts to evaluate our business and prospects. You must consider our business and prospects in light of the risks and difficulties we may face as an early stage company with limited operating history. These risks and difficulties include challenges in accurate financial planning as a result of limited historical data and operating experience and the uncertainties resulting from having had a relatively limited time period in which to implement and evaluate our business strategies as compared to older companies with longer operating histories. Our failure to successfully address these risks and difficulties would seriously harm our business.
We have a history of significant losses. If we do not achieve or sustain profitability, our financial condition and stock price could suffer.
We have a history of losses and we may continue to incur losses for the foreseeable future. As of April 2, 2006, our accumulated deficit was $89.4 million. We have not achieved profitability for a full fiscal year. If our revenues grow more slowly than we anticipate, or if our operating expenses exceed our expectations, we may not be able to achieve full fiscal year profitability in the near future or at all. Even if we do achieve full fiscal year profitability, we may not be able to sustain or increase profitability on a quarterly or annual basis in the future. If we are unable to achieve full fiscal year profitability within a short period of time, or at all, or if we are unable to sustain profitability at satisfactory levels, our financial condition and stock price could be adversely affected.
Because we experience seasonal fluctuations in our net sales, our quarterly results will fluctuate and our annual performance will depend largely on results from one quarter.
Our business is highly seasonal, reflecting the general pattern of peak sales for the retail industry during the holiday shopping season. Typically, a substantial portion of our net revenues occur during our third fiscal quarter ending around December 31. We generally experience lower net revenues during the first, second and fourth fiscal quarters and, as is typical in the retail industry, have incurred and may continue to incur losses in these quarters. The third fiscal quarter accounted for approximately 46.9% of net revenues in the fiscal year ended April 2, 2006. We cannot predict with certainty what percentage of our total net revenues for fiscal year 2007 will be represented by our third fiscal quarter revenues. In anticipation of increased sales activity during the third fiscal quarter, we incur significant additional expenses, including significantly higher inventory and staffing costs. If sales for the third fiscal quarter do not meet anticipated levels, then increased expenses may not be offset, which would adversely affect our financial condition. If we were to experience lower than expected sales during our third fiscal quarter, for whatever reason, it would have a disproportionately large negative impact on our annual operating results and financial condition for that fiscal year. If our net revenues during our third fiscal quarter were to fall below projections or the expectations of securities analysts, our stock price could decline, perhaps significantly.
Our operating results are volatile and difficult to predict and may adversely affect our stock price.
Our annual and quarterly operating results have fluctuated in the past and may fluctuate significantly in the future due to a variety of factors including those discussed in this report, many of which are outside of our control. Further, because our business is seasonal, our operating results may vary significantly from one quarter to the next as part of our normal business cycle. As a result, we believe that quarterly comparisons of our operating results are not necessarily meaningful and that you should not rely on the results of one quarter as an indication of our future performance. It is likely that in some future quarter our operating results may fall below projections or the expectations of securities analysts and investors. In this event, the trading price of our common stock could decline, perhaps significantly.
Our computer and communications hardware and software systems are vulnerable to damage and interruption, which could harm our business.
Our ability to receive and fulfill orders successfully through our website is critical to our success and largely depends upon the efficient and uninterrupted operation of our computer and communications hardware and software systems. Our systems and operations are vulnerable to damage or interruption from power outages, computer and telecommunications failures, computer viruses, security breaches, catastrophic events
(such as natural disasters or terrorist attacks), and errors in usage by our employees and customers. The uninterrupted operation of our computer and communications hardware and software systems may also be dependent upon the continued performance of third party vendors and/or service providers with whom we have contracted. In the event that one of our third party service providers fails for any reason to perform its obligations in a timely or efficient manner, or at all, our operations could be interrupted or adversely affected or we could be required to incur additional, unanticipated costs. Further, our servers are located at the facilities of, and hosted by, a third-party service provider in San Francisco, California. In the event that this service provider experiences any interruption in its operations or ceases operations for any reason or if we are unable to agree on satisfactory terms for a continued hosting relationship, we could be forced to enter into a relationship with another service provider or take over hosting responsibilities ourselves. In addition, we are in the process of eliminating our redundant data center that we had in Cincinnati, Ohio. We currently plan to establish a failover system at our primary data center for all of our production systems during the second quarter of fiscal 2007, although we currently believe that this will not occur prior to the elimination of the Cincinnati, Ohio facility. There can be no assurances that we will accomplish this task in this timeframe or at all. We cannot assure you that, in the event it became necessary to switch hosting facilities, we would be successful in finding an alternative service provider on acceptable terms or in hosting the computer servers ourselves. Any significant loss of data or interruption in the availability or functionality of our website, or our sales processing, fulfillment or communications systems for any reason, particularly an interruption during the holiday season, could seriously harm our business and operating results. And, any significant additional expenses incurred as a result of any failure by a third party to perform obligations in a timely or efficient manner or any significant costs associated with finding a new vendor or service provider or taking over responsibilities ourselves would have an adverse impact on our business, financial condition and operating results.
If we fail to offer a broad selection of innovative merchandise that consumers find attractive, our revenues could decline or fail to reach anticipated levels and our stock price could be harmed.
In order to meet our strategic goals, we must successfully offer, on a continuous basis, a broad selection of appealing products. These products must satisfy the diverse tastes of our customers and potential customers for a variety of gift-giving occasions. To be successful, our product offerings must be competitively priced, well made, innovative and attractive to a wide range of consumers whose preferences may change regularly. We cannot predict with certainty that we will be successful in offering products that meet these requirements. If our products become less popular with consumers, our revenues may decline or fail to meet expected levels or we may decide to offer our products at lower prices. If a wide range of consumers do not find our products attractive or if we are required to reduce our prices, our revenues and earnings may decline or fail to meet expected levels and our stock price could be affected adversely.
Failure to successfully manage or expand our fulfillment and distribution operation would have a material adverse effect on us.
Our fulfillment and distribution operation is located in leased facilities in Lockbourne, Ohio. We have limited experience and have encountered difficulties in the past managing our fulfillment and distribution operations, and we may encounter difficulties managing our fulfillment and distribution operations in the future. If we are unable to manage successfully our fulfillment and distribution operations and to meet our customers’ expectations regarding personalization, presentation and delivery, our business reputation, operations and financial condition could be seriously harmed. Further, any difficulty in managing our fulfillment and distribution operations could require us to find one or more parties to provide these services for us. If we are required to engage one or more service providers, we could incur higher fulfillment expenses than anticipated or incur additional costs for balancing merchandise inventories among multiple fulfillment facilities. Further, we currently anticipate that we will need to expand and upgrade our fulfillment operations in the future to accommodate increases in customer orders, increased demand for personalized products or changes in available technology. If we fail to successfully manage, expand or make necessary upgrades to our fulfillment and distribution operations in a timely and cost-effective manner, it would have a material adverse effect on our business.
If we do not manage our inventory levels successfully, our operating results may be adversely affected.
We must maintain sufficient inventory levels to operate our business successfully. Rapidly changing trends in consumer tastes for gift items expose us to significant inventory risks, particularly during our third fiscal quarter when inventory levels are highest due to the holiday shopping season. Consumer preferences can change between the time we order a product and the time it is available for sale. We base our product selection on our projections of consumer tastes and preferences in a future period, and we cannot guarantee that our projections of consumer tastes and preferences will be accurate. It is critical to our success that we accurately predict consumer tastes and stock our product offerings in appropriate quantities. In the event that one or more products do not achieve widespread consumer acceptance, we may be required to take significant inventory markdowns, which could reduce our net sales and gross margins. This risk may be greatest in the third fiscal quarter of each year, after we have significantly increased inventory levels for the holiday shopping season. In addition, to the extent that demand for our products increases over time, we may be forced to increase inventory levels. Any such increase would require the use of additional working capital and subject us to additional inventory risks. Further, our failure to stock sufficient quantities of popular products would likely cause us to miss revenue opportunities and could cause our customers to become dissatisfied and look to our competitors for their gift items, which could also harm our business and reputation. In the past, some of our popular items were not stocked in quantities sufficient to meet the demand for such items, which likely led to missed sales opportunities. If we fail to stock popular products in sufficient quantities or if we overstock products, our business, financial condition and operating results would be affected adversely.
We may have difficulty in product sourcing.
A significant portion of our products are unique designs manufactured by third-parties. However, since we do not have long-term arrangements with any manufacturer, vendor or distributor that would guarantee the availability of products from year to year, we do not have a predictable or guaranteed supply of these products in the future. If we are unable to provide our customers with continued access to popular products, our operating results will be harmed.
In addition, we may not receive products from our suppliers in a timely manner or we may receive products from our suppliers that do not meet our quality standards. From time to time, we receive products from suppliers that are of insufficient quality to provide to our customers. Generally the supplier is able to quickly rectify the problem, but occasionally we have been unable to obtain replacement product quickly enough to fulfill all customer orders for such product in a timely manner, particularly with respect to items sourced overseas which tend to have longer delivery lead time requirements. If we do not receive products from our suppliers in a timely manner or if we receive products from our suppliers that do not meet our high quality standards and we are unable to obtain suitable replacement products in a timely manner, our reputation and our operating results could be harmed. Further, customers who do not receive their products in a timely manner may look to our competitors for their gift items.
Many of our products are sourced overseas. While products sourced overseas typically have lower costs, our product margins may be offset by an increase in inbound freight costs. As security measures around shipping ports increase, these additional costs may result in higher inbound freight costs. Increasing competition for overseas production resources, particularly in China, may result in higher than anticipated product costs and lower product margins. Furthermore, in recent years, U.S. companies were subject to port strikes which delayed the delivery of goods. As we increase our overseas sourcing, we face the risk of these delays which could seriously harm our business and results of operations. We cannot predict whether any of the countries in which our merchandise currently is manufactured or may be manufactured in the future will be subject to additional trade restrictions imposed by the U.S. and other foreign governments, including the likelihood, type or effect of any such restrictions. Trade restrictions, including increased tariffs or quotas, embargoes, and customs restrictions, against items that we offer or intend to offer to our customers, as well as U.S. or foreign labor strikes, work stoppages or boycotts, could increase the cost or reduce the supply of items available to us and adversely affect our business, financial condition and results of operations. Our sourcing operations also may be adversely affected by political and financial instability resulting in the disruption of trade from exporting countries, significant fluctuation in the value of the U.S. dollar against foreign currencies,
restrictions on the transfer of funds and/or other trade disruptions. Any disruption or delays in, or increased costs of, importing our products could have an adverse effect on our business, financial condition and operating results.
Our operating results could suffer if we fail to offer or sell sufficient quantities of proprietary products.
In recent periods, the majority of our most popular products have been designed in-house or were otherwise exclusive to RedEnvelope. As proprietary products generally carry higher gross margins than widely available products, any failure to offer and sell large numbers of proprietary products could prevent us from achieving our gross margin objectives. If we are unable for any reason to design or source popular proprietary products or if we are unable to sell sufficient quantities of proprietary products during any future period, our operating results will be adversely affected.
Our facilities and systems are vulnerable to natural disasters or other catastrophic events.
Our headquarters, customer sales and service center and the majority of our infrastructure, including computer servers, are located in California, an area that is susceptible to earthquakes and other natural disasters. Our distribution facility, located in Lockbourne, Ohio, houses substantially all of our product inventory and is the location from which substantially all of our orders are shipped. A natural disaster or other catastrophic event, such as an earthquake, fire, flood, severe storm, break-in, terrorist attack or other comparable problems could cause interruptions or delays in our business and loss of inventory and/or data or render us unable to accept and fulfill customer orders in a timely manner, or at all. Further, California has in the recent past experienced power outages as a result of limited electrical power supplies. These outages may recur in the future and we cannot determine the effect, if any, that such outages would have on the operation of our business. In addition, as our inventory and distribution facility is located in an area that is susceptible to harsh weather, a major storm, heavy snowfall or other similar event could prevent us from delivering products in a timely manner. Also, areas in and around San Diego, California, the site of our customer sales and service facility, have in the past experienced severe wildfires. The occurrence of any such wildfires in the future could destroy, render inoperable or cause the evacuation of our customer sales and service facility, which could significantly disrupt our ability to provide satisfactory customer sales and service. We have no formal disaster recovery plan and our business interruption insurance may not adequately compensate us for losses that may occur from any of the foregoing. In the event that an earthquake, natural disaster or other catastrophic event were to destroy any part of our facilities or interrupt our operations for any extended period of time, or if harsh weather conditions prevent us from delivering products in a timely manner, our business, financial condition and operating results could be seriously harmed.
We have grown quickly and if we fail to manage our growth, our business will suffer.
We have rapidly and significantly expanded our operations, and anticipate that further significant expansion, including the possible acquisition of third-party assets, technologies or businesses, will be required to address market opportunities and desired growth in our customer base. Prior expansion has placed, and any future expansion is expected to continue to place, a significant strain on our management, operational and financial resources. Some of our officers and senior management personnel have no prior senior management experience at public companies. We have experienced significant turnover among our executive officers in recent years and our President and Chief Executive Officer, Chief Financial Officer, and Chief Operating Officer have only been with the Company for a short period of time. In addition, we have hired a number of key managerial, technical, finance, accounting and operations personnel in the recent past. As a result, key members of our management and employee team are still in the process of being integrated into our operations. Additionally, we need to properly implement and maintain our financial and managerial controls, reporting systems and procedures, including the increased internal controls and procedures required by the Sarbanes Oxley Act of 2002. Moreover, if we are presented with appropriate opportunities, we may in the future make investments in, or possibly acquire, assets, technologies or businesses that we believe are complementary to ours. Any such investment or acquisition may further strain our financial and managerial controls and reporting systems and procedures. These difficulties could disrupt or make it more difficult to plan
and forecast our business, distract our management and employees or increase our costs. If we are unable to manage growth effectively, including integration of new personnel, implement proper controls and systems in an efficient manner, or successfully integrate any assets, technologies or businesses that we may acquire, or if we acquire assets, technologies or business that do not prove complimentary to us, our business, financial condition and results of operations would be affected adversely.
We experience intense competition in the rapidly changing retail gift market.
We operate in a highly competitive environment. We principally compete with a variety of department stores, Internet retailers, specialty retailers and other catalog merchants that offer products similar to or the same as our products. Increased competition is likely to result in price reductions, reduced gross margins and loss of market share, any of which could seriously harm our net revenues and results of operations. We expect competition to intensify in the future because current and new competitors can enter our market with little difficulty and can launch new websites at a relatively low cost. We currently or potentially compete with a variety of other companies, including:
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other online retailers, such as Amazon.com and eBay
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major department stores, such as Macy’s, Bloomingdale’s, Neiman Marcus and their online storefronts
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physical and online stores and catalog retailers that sell popular gift items such as Pottery Barn, Brookstone, The Sharper Image, Tiffany’s, Harry & David, J Crew, 1-800-Flowers and Williams-Sonoma
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Internet portals and online service providers and other comparison shopping sites, such as AOL, Yahoo! and Google.
Many of our traditional store-based, catalog-based and online competitors have longer operating histories, larger customer or user bases, greater brand recognition and significantly greater resources, particularly financial and marketing resources. Many of these competitors can devote substantially more resources to website development and catalog retailing than we can. In addition, large, well-established and well-financed entities may establish more robust online sales operations in the future. Our competitors may be able to secure products from vendors on more favorable terms, provide popular products to which we do not have access, fulfill customer orders more efficiently and adopt more aggressive pricing or inventory availability policies than we can.
The U.S. retail industry, the specialty retail industry in particular, and the online commerce sector are highly competitive, dynamic in nature and have undergone significant changes over the past several years and will likely continue to undergo significant changes. Our ability to anticipate and respond successfully to these changes is critical to our long-term growth and we cannot assure you that we will anticipate and respond effectively to changes in the retail industry and online commerce sectors. If we are unable to maintain or increase our market share or compete effectively in the retail gift market, our business, financial condition and operating results would be affected adversely.
If we do not successfully expand our website and order processing systems or respond to rapid technological changes, we could lose customers and our net revenues could decline.
If we fail to upgrade our website in a timely manner to accommodate higher volumes of traffic, our website performance could suffer and we may lose customers. In addition, if we fail to expand the computer systems that we use to process and ship customer orders and process customer payments, we may not be able to fulfill customer orders successfully. As a result, we could lose customers and our net revenues could be reduced. Further, to remain competitive, we must continue to enhance and improve the functionality and features of our online store. The Internet and the online commerce industry are subject to rapid technological change. If competitors introduce new features and website enhancements, or if new industry standards and practices emerge, our existing website and systems may become obsolete or unattractive. Developing and enhancing our website and other systems entails significant technical and business risks. We may use new technologies ineffectively or we may fail to adapt our website, our transaction processing systems and our computer network to meet customer requirements or emerging industry standards. If we are unsuccessful in
upgrading our systems to accommodate higher traffic or developing or implementing new technologies that enable us to meet evolving industry standards and remain competitive, our operating results would be seriously harmed.
We are currently in the process of implementing new website and inventory planning software systems. Also, we are in the process of modifying certain internal processes for the purpose of improving our productivity and making our operations more cost efficient. However, we cannot assure you that we will be successful in these efforts. Possible cost overruns in these implementation efforts may result in higher than anticipated capital expenditures and delays in or other problems arising out of these implementations could lead to customer dissatisfaction. If we do not successfully implement one or more of these intended upgrades or modified processes or if we do not achieve desired efficiencies or cost savings as a result of these changes or if attempts to enhance our website are unsuccessful or are not appealing to our customers, our business and operating results could be harmed, perhaps significantly.
Delivery of our merchandise could be delayed or disrupted by factors beyond our control, and we could lose customers as a result.
As timely gift delivery is essential to our customer’s satisfaction, any delay disruption or inaccuracy in order, fulfillment and delivery for any reason, particularly during the holiday shopping season, could cause us to lose customers and negatively affect our business and reputation. In addition, we rely upon third-party carriers for timely delivery of our product shipments. As a result, we are subject to carrier disruptions and delays due to factors that are beyond our control, including employee strikes and inclement weather.
The loss of our senior management or other key personnel could harm our current and future operations and prospects.
Our performance is substantially dependent on the continued services and on the performance of our senior management and other key personnel. Three of our former officers, Edward Schmults, our former Chief Operating Officer, Kristine Dang, our former Executive Vice President, Merchandising and Alison May, our former Chief Executive Officer and President each resigned from RedEnvelope during fiscal 2006. We have not yet filled the merchandising position formerly held by Ms. Dang. While we believe that this will have no material impact on our operations, we cannot assure you that disruptions occasioned by their departures or that running our business without certain key officers will not have an adverse impact on our operations. Our performance also depends on our ability to retain and motivate other officers and key employees. We have recently hired Ken Constable as our President and Chief Executive Officer and Frank Buettner as our Chief Operating Officer. Polly Boe, our Chief Financial Officer, has been with the Company for just over one year. We do not have long-term employment agreements with these individuals or any of our key personnel. The loss of the services of Mr. Constable, Ms. Boe, Mr. Buettner, Mr. Korotzer or Mr. Nordquist or other key employees for any reason could harm our business, financial condition and operating results. Our future success also depends on our ability to identify, attract, hire, train, retain and motivate other highly skilled technical, managerial, editorial, merchandising, marketing and customer sales and service personnel. Competition for such personnel is intense, particularly in the San Francisco Bay Area, and we cannot assure you that we will be able to successfully attract, assimilate or retain sufficiently qualified personnel. Our failure to attract and retain the necessary technical, managerial, editorial, merchandising, marketing and customer sales and service personnel would harm our business, financial condition and results of operations. Moreover, competition is particularly intense for highly-qualified senior officers in our industry, and a variety of factors could make it difficult for us to attract the right candidates in the near term or at all. In the event that we cannot hire and retain qualified senior officers in a timely manner, our business could be adversely affected.
We rely on seasonal and temporary employees during periods of peak activity and any failure by such employees to adequately perform their jobs could adversely affect our operations.
We depend on temporary and seasonal employees to adequately staff our fulfillment facility and customer sales and service facilities during busy periods such as the holiday shopping season, including individuals responsible for gift personalization and packaging and responding to consumer inquiries. Temporary employ-
ees may not have the same levels of training or commitment as full-time employees and, as a result, may be more likely to provide unsatisfactory service. We cannot assure you that we will continue to receive adequate assistance from our temporary employees, or that we will continue to have access to sufficient numbers of competent temporary employees on a cost-effective basis, particularly during the holiday shopping season, which season is critical to our business. If we are unable to adequately staff our fulfillment and customer sales and service facilities, particularly during the holiday shopping season and other periods of increased activity or if our temporary and seasonal employees do not provide satisfactory service, our operations and sales during such period could suffer, and our reputation could be harmed.
Increased merchandise returns and a failure to accurately predict merchandise returns could harm our business.
As part of our customer service commitment, we maintain a merchandise return policy that allows recipients to return merchandise received from us if they are dissatisfied with those items (except under certain circumstances, personalized products). We make allowances for merchandise returns in our financial statements based on historical return rates and other factors. We cannot assure you that actual merchandise returns will not significantly exceed our allowances for returns. In addition, because our allowances are based on historical return rates, we cannot assure you that the introduction of new merchandise in our catalogs, the introduction of new catalogs, increased sales over the Internet, changes in our merchandise mix, changes in the habits of our gift item recipients, or other factors will not cause actual returns to exceed return allowances, perhaps significantly. Any increase in merchandise returns that exceed our allowances would affect our business adversely. Also, returned merchandise that is personalized, perishable, or damaged likely cannot be re-sold, creating non-recoverable inventory costs which detrimentally affects our operating results.
If we are unable to successfully manage the costs of our catalog operations or our catalogs fail to produce sales at satisfactory levels it could adversely affect our business.
Our catalog has been an important tool for the acquisition and retention of customers. We believe that the success of our catalog as a cost-effective marketing tool depends on the following factors:
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effective management of costs associated with the production and distribution of our catalog
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achievement of adequate response rates to our mailings
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displaying a mix of merchandise in our catalog that is attractive to our customers
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production of aesthetically appealing catalogs
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timely delivery of catalog mailings to our customers
Catalog production and mailings entail substantial paper, printing, postage and human labor costs. Increases in the costs of producing and distributing the RedEnvelope catalog, including increases in postage rates or paper, photography, or printing costs, may reduce the margin on sales derived from our catalog. The U.S. Postal Service is likely to increase its postage rates in the future and other delivery and overnight courier services that we utilize to deliver our products also will likely raise their rates in the future, which could significantly increase the aggregate cost of mailing our catalogs. As we incur nearly all of the costs associated with our catalogs prior to mailing, we are unable to adjust the costs being incurred in connection with a particular mailing to reflect the actual performance of the catalog. In addition, response rates to our mailings and, as a result, revenues generated by each mailing, are affected by factors such as constantly changing consumer preferences and our ability to include a product assortment that satisfies those preferences, economic conditions, the timing and mix of catalog mailings, the timely delivery by the postal system of our catalog mailings, and changes in our merchandise mix, several or all of which may be outside of our control. In recent periods, we have experienced slower growth in revenues from our catalog channel than in our online channels and we expect this trend towards slower catalog growth to continue. If we were to experience an increase in the costs associated with producing or delivering our catalogs or a delay in distributing our catalogs or if our catalogs fail to produce sales at satisfactory levels, our operating results would be adversely affected.
We are dependent on the success of our advertising and marketing efforts which are costly and may not achieve desired results.
Our revenues depend on our ability to advertise and market our products effectively through the RedEnvelope catalog and other advertising and marketing efforts. If we do not successfully advertise and market our products, our operating results will be seriously harmed. Increases in the cost of advertising and marketing, including paper and postage costs, the costs of online marketing and the costs of complying with applicable regulations, may limit our ability to advertise and market our business in a cost-effective manner. In addition, individuals are increasingly using software programs that block certain email marketing campaigns, and certain federal and state laws and regulations may restrict our ability to effectively utilize email as a marketing tool. If we decrease our advertising, or marketing activities, if the effectiveness of such activities is diminished, due to increased costs, restrictions enacted by regulatory agencies or for any other reason, or if our current advertising strategy does not yield anticipated results, our future operating results could be significantly harmed.
If we are unable to provide satisfactory customer service, we could lose customers.
Our ability to provide satisfactory levels of customer service depends, to a large degree, on the efficient and uninterrupted operation of our call center. Any material disruption or slowdown in our order processing systems resulting from labor disputes, telephone or Internet failures, power or service outages, natural disasters or other events could make it difficult or impossible to provide adequate customer service and support. Further, we may be unable to attract and retain adequate numbers of competent customer service representatives, which is essential in creating a favorable interactive customer experience. Due to increased customer service needs during the holiday shopping season, we hire a relatively large number of temporary employees during our third fiscal quarter. As a result, we may have difficulty properly staffing our customer service operations during our peak sales season. If we are unable to continually provide adequate staffing for our customer service operations, our reputation could be seriously harmed.
In addition, we cannot assure you that email and telephone call volumes will not exceed our present system capacities. If this occurs, we could experience delays in placing orders, responding to customer inquiries and addressing customer concerns. Although we are currently implementing plans to expand its capacity, our customer sales and service facility currently accommodates customer sales and service representatives at close to its capacity during our peak sales period. Because our success depends in large part on keeping our customers satisfied, any failure to provide high levels of customer sales and service or adequately staff our customer sales and service operations would likely impair our reputation and have an adverse effect on our business and operating results.
If the protection of our trademarks and proprietary rights is inadequate, our brand and reputation could be impaired and we could lose customers.
We regard our copyrights, service marks, trademarks, trade dress, trade secrets and similar intellectual property as critical to our success. We rely on trademark and copyright law, trade secret protection and confidentiality agreements with our employees, consultants, partners, suppliers, and others to protect our proprietary rights. Nevertheless, the steps we take to protect our proprietary rights may be inadequate. Further, effective trademark, service mark, copyright and trade secret protection may not be available in every country in which we may sell our products and offer our services or whose residents have access to our website presently or in the future. In addition, the relationship between regulations governing domain names and laws protecting trademarks and similar proprietary rights is unclear. Therefore, we may be unable to prevent third parties from acquiring domain names that are similar to, infringe upon or otherwise decrease the value of our trademarks and other proprietary rights. If we are unable to protect or preserve the value of our trademarks, copyrights, trade secrets or other proprietary rights for any reason, our business would be harmed.
We also rely substantially on technologies that we license from third parties. These licenses may not continue to be available to us on commercially reasonable terms, or at all, in the future. As a result, we may be required to develop or obtain substitute technology of lower quality or at greater cost, or we may be prevented
from providing features or functionality on our website that our customers and potential customers desire, any of which could materially adversely affect our business, operating results and financial condition.
Intellectual property claims against us could be costly and could impair our business.
Other parties may assert infringement or unfair competition claims against us. In the past, we have been subject to claims or received notices from third parties alleging that our trademarks or product offerings infringe proprietary rights held by them. From time to time we also receive claims and become a defendant in lawsuits alleging that our Internet marketing program and website operations infringe patents held by third parties. We cannot predict whether third parties will assert claims of infringement against us, or whether any past, present or future claims will prevent us from offering popular products or operating our business as planned. If we are forced to defend against third-party infringement claims, whether they are with or without merit or are determined in our favor, we could face expensive and time-consuming litigation, which could distract technical and management personnel, or result in product shipment delays. If an infringement claim is determined against us, we may be required to pay monetary damages or ongoing royalties. Further, as a result of infringement claims either against us or against those who license technology to us, we may be required to develop non-infringing intellectual property or enter into costly royalty or licensing agreements. Such royalty or licensing agreements, if required, may be unavailable on terms that are acceptable to us, or at all. If a third-party successfully asserts an infringement claim against us and we are required to pay monetary damages or royalties or we are unable to develop suitable non-infringing alternatives or license the infringed or similar intellectual property on reasonable terms on a timely basis, it could significantly harm our business.
We may be subject to litigation proceedings that could adversely affect our business.
In addition to the litigation risks mentioned above, it is possible that, in the course of our business, we could be subject to legal claims or proceedings involving consumer, employment, stockholder, contract or other matters. If we are required to defend against a legal claim or deem it necessary or advisable to initiate a legal proceeding to protect our rights, the expense and distraction of such a claim or proceeding, whether or not resolved in our favor, could adversely affect our business. Further, if a claim or proceeding were resolved against us or if we were to settle any such dispute, we could be required to pay damages or refrain from certain activities, which could have an adverse impact on our business, financial condition and operating results.
We face the risk of inventory shrinkage.
We are subject to the risk of inventory loss and theft. Although we believe that the levels of inventory shrinkage that we have suffered in the past are within an acceptable range, we cannot assure you that incidences of inventory loss and theft will not increase in the future or that the security measures we have taken in the past will effectively address the problem of inventory theft. If we were to suffer higher rates of inventory shrinkage or incur increased security costs to combat inventory theft, our financial condition could be affected adversely.
Poor economic conditions may constrain discretionary consumer spending on retail products such as ours.
Consumer spending patterns, particularly discretionary spending for products such as ours, are affected by, among other things, prevailing economic conditions, stock market volatility, wars, threats of war, acts of terrorism, wage rates, interest rates, inflation, taxation, and consumer confidence. General economic, political and market conditions, such as recessions, may adversely affect our business results and the market price of our common stock. Our business and revenues have been, and in the future could be, negatively affected by poor economic conditions and any related decline in consumer demand for discretionary items such as our products. We face uncertainty in the degree to which poor performance in the retail industry, decreased consumer confidence or any economic slowdown will negatively affect demand for our products. We may not be able to accurately anticipate the magnitude of these effects on future quarterly results, which could seriously harm our financial condition. As we do not have large cash reserves, we may not be able to survive an extended recession or sluggish economy.
If we fail to meet the borrowing requirements under our loan and security agreement, we may be unable to obtain necessary short-term financing and if we default on a secured loan, material assets of ours could be subject to forfeiture.
From time to time, we may experience the need to obtain funding to meet short-term cash requirements, such as the acquisition of inventory prior to our holiday selling season. We currently are party to a loan and security agreement which provides us with a revolving credit facility for the primary purpose of enabling us to satisfy any such funding needs. However, as is typical for agreements of this sort, the loan and security agreement requires us to meet certain financial conditions as a prerequisite to obtaining and maintaining loans thereunder and we can offer no assurances that we will be able to meet such conditions when a loan is needed or continue to meet such conditions when a loan is outstanding. If we are unable to meet the conditions for borrowing under our loan and security agreement when funds are required, we could be prevented from purchasing sufficient inventory to meet our revenue and profitability objectives or from meeting other payment obligations, which could have a material adverse effect on our business, financial condition and operating results. Further, if we were to breach such financial conditions while a loan is outstanding under the loan and security agreement, it could constitute a default under that agreement which could require immediate repayment of amounts owed under the agreement.
Further, our obligations under the loan and security agreement are secured by substantially all of our tangible and intangible assets, including intellectual property. If we default under our loan and security agreement for any reason and are unable to cure the default pursuant to the terms of that agreement, our lenders could take possession of any or all of our assets in which they hold a security interest, including intellectual property, and dispose of those assets to the extent necessary to pay off our debts, which could materially harm our business.
The loan and security agreement also contains a covenant that prohibits us from paying cash dividends to our stockholders.
We may need additional financing and may not be able to raise additional financing on favorable terms or at all, which could increase our costs, limit our ability to grow and dilute the ownership interests of existing stockholders.
We anticipate that we may need to raise additional capital in the future to facilitate long-term expansion, to respond to competitive pressures or to respond to unanticipated financial requirements. Since our inception, we have experienced negative cash flow from operations on a fiscal year basis and may experience negative cash flow from operations on a fiscal year basis in the future. We cannot be certain that we will be able to obtain additional financing on commercially reasonable terms or at all. If we raise additional funds through the issuance of equity, equity-related or debt securities, such securities may have rights, preferences or privileges senior to those of the rights of our common stock and our stockholders would experience dilution of their ownership interests. We may also be subject to high interest rates or substantial restrictive covenants. Further, under the terms of our loan and security agreement, we are subject to certain contractual limitations with respect to raising additional capital during the term of that agreement. Any failure to obtain necessary capital on commercially reasonable terms could have severe consequences on our business. Further, an inability to obtain additional financing could require us to scale back, or fail to address opportunities for expansion or enhancement of, our operations.
We may face product liability claims that are costly and create adverse publicity.
If any of the products that we sell causes harm or financial damages to any of our customers or other individuals, we could be vulnerable to product liability lawsuits. If we are found liable under product liability claims, we could be required to pay substantial monetary damages and our reputation could suffer. Further, even if we successfully defend ourselves against this type of claim, we could be forced to spend a substantial amount of money in litigation expenses, our management could be required to spend valuable time in the defense against these claims and the claims could bring adverse publicity to us, any of which could harm our business.
We may incur significant costs or experience delays in product availability due to regulations applicable to the sale of food products and live plants, which may hurt our business.
We currently offer select food items and live plants for sale to our customers. Applicable federal, state or local regulations may cause us to incur substantial compliance costs or delay the availability of those products. In addition, any inquiry or investigation from a regulatory authority could have a negative impact on our reputation. The occurrence of any of these events could adversely affect our financial condition.
If we fail to comply with the laws regulating the sale of tobacco products it may have a negative impact on our reputation and make us vulnerable to liability claims.
Although we ceased selling tobacco products in June 2006, we have been required to comply with a range of regulatory requirements, including age verification in connection with the sale of our tobacco products. If we have failed to comply with such regulations or are unable to properly identify the age of our purchasers, we could face substantial penalties and legal liability. Any inquiry or investigation from a regulatory authority could have a negative impact on our reputation and any liability claims could subject us to fines, mandatory damages or require us to spend significant time and money in litigation, any of which could adversely affect our business, financial condition and operating results.
Our charter documents, Delaware law and third-party contractual restrictions may make an acquisition of us more difficult, even if an acquisition would be beneficial to our stockholders.
We are a Delaware corporation and the Delaware General Corporation Law contains certain provisions that may make a change in control of our company or the removal of incumbent directors more difficult. In addition, our Amended and Restated Certificate of Incorporation and Bylaws, contain provisions that may have the same effect, including the elimination of the ability of stockholders to call special meetings or vote by written consent, the elimination of cumulative voting for directors, and procedures requiring advance notification for stockholder proposals. The elimination of cumulative voting substantially reduces the ability of minority stockholders to obtain representation on the Board of Directors. Also, the Board of Directors may determine at some point in the future that it is in the best interests of the Company and its stockholders to enact additional measures to protect the Company against unsolicited takeovers or stock accumulation. Such provisions or the enactment of additional protective measures may discourage potential acquirers from making a bid for our company, or make an acquisition of us or a tender offer to our stockholders more difficult, even if such acquisition or tender offer would be beneficial to our stockholders, and may reduce any premiums paid to stockholders for their common stock.
Additionally, under the terms of our loan and security agreement, we are subject to covenants that could restrict or place limitations on our ability to be acquired by another company during the term of the loan and security agreement, even if such acquisition would be beneficial to our stockholders.
Our success is tied in large part to the continued use of the Internet by a large number of consumers.
Our future revenues and profits, if any, substantially depend upon the continued widespread use of the Internet as an effective medium of commerce and communication. Factors which could reduce the widespread use of the Internet include:
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actual or perceived lack of privacy protection
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actual or perceived lack of security of credit card information
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possible disruptions or other damage to the Internet or telecommunications infrastructure
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increased governmental regulation and taxation
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decreased use of personal computers
Any decrease or less than anticipated growth in Internet usage could significantly harm our business.
Customers may be unwilling to purchase goods on the Internet.
As of April 2, 2006, approximately 80% of our customer orders were placed through our website. Our long-term prospects therefore depend upon the general public’s increasing willingness to use the Internet as a means to purchase goods. The failure of the Internet to continue to develop into an effective and reliable tool for consumer purchases would seriously damage our future operations. Online commerce is a relatively new concept, and online purchases may decline or fail to increase as projected. The future of online commerce is uncertain, many online commerce companies have ceased operations in recent years and most existing online commerce companies have a relatively short operating history. If consumers are unwilling to use the Internet to purchase retail products, our business will be significantly harmed.
The security risks of online commerce, including credit card fraud, may discourage customers from purchasing goods from us.
In order for the online commerce market to develop successfully, we and other market participants must be able to transmit confidential information, including credit card information, securely over public networks. Third parties may have the technology or know-how to breach the security of customer transaction data. Any breach could cause consumers to lose confidence in the security of our website and choose not to purchase from us. Although we take the security of our systems very seriously, we cannot guarantee that our security measures will effectively prohibit others from obtaining improper access to our information and information of our customers. If a person is able to circumvent our security measures, he or she could destroy or steal valuable information or disrupt our operations. Any security breach could expose us to risks of data loss, litigation and liability and could seriously disrupt our operations and harm our reputation, any of which could adversely affect our business.
We do not carry insurance against the risk of credit card fraud, so the failure to prevent fraudulent credit card transactions could reduce our net revenues and gross margin. We may suffer losses as a result of orders placed with fraudulent credit card data even though the associated financial institution approved payment of the orders. Under current credit card practices, we may be liable for fraudulent credit card transactions because we do not obtain a cardholder’s signature. If we are unable to detect or control credit card fraud, our liability for these transactions could harm our business, operating results and financial condition.
Existing or future government regulation could harm our business.
We are subject to the same federal, state and local laws as other companies conducting business on the Internet, including consumer protection laws, user privacy laws and laws and regulations prohibiting unfair and deceptive trade practices. In particular, under federal and state financial privacy laws and regulations, we must provide notice to our customers of our policies and practices regarding non-public personal information that we collect and use, including whether we share that information with third parties, must provide advance notice of any changes to our privacy policies and must inform our customers about how they can review and/or correct the non-public personal information we possess about them. Further, the growth of online commerce could result in more stringent consumer protection laws that impose additional compliance burdens on us. Today there are an increasing number of laws specifically directed at the conduct of business on the Internet. Moreover, due to the increasing use of the Internet, many additional laws and regulations relating to the Internet are being debated at the state and federal levels. These laws and regulations could cover issues such as freedom of expression, pricing, consumer privacy, fraud, quality of products and services, taxation, advertising, adult-oriented content, defamation, intellectual property rights, identity theft and information security. Applicability of existing laws to the Internet relating to issues such as trademarks, copyrights and other intellectual property issues, taxation, libel, obscenity and personal privacy could also harm our business. For example, United States and international laws regulate our ability to use customer information and to develop, buy and sell mailing lists. Many of these laws were adopted prior to the advent of the Internet, and do not contemplate or address the unique issues raised by the Internet. Those laws that do reference the Internet, such as the Digital Millennium Copyright Act and the recent federal law regulating the commercial use of e-mail (popularly known as “CAN-SPAM”), are only beginning to be interpreted by the courts and their applicability and reach are therefore uncertain. The restrictions imposed by, and costs of complying with,
current and possible future laws and regulations related to our business could harm our business, operating results and financial condition.
In 2003, the California legislature enacted new sections of the Civil Code that require any company that does business in California and possesses computerized data, in unencrypted form, containing certain personal information about California residents to (i) provide prompt notice to such residents if that personal information was, or is reasonably believed to have been, obtained by an unauthorized person such as a computer hacker and (ii) implement and maintain reasonable security procedures and practices to protect that information from unauthorized access, destruction, use, modification or disclosure. The law defines personal information as an individual’s name together with one or more of that individual’s social security number, driver’s license number, California identification card number, credit card number, debit card number, or bank account information, including any necessary passwords or access codes. In 2004, the California legislature enacted another new section of the Civil Code that requires any company that owns or licenses personal information about California residents to implement and maintain “reasonable security procedures and practices” to protect that information from unauthorized access, destruction, use, modification or disclosure. The law also requires that any company that discloses personal information about California residents to a nonaffiliated third party must require by contract that that party also implement and maintain “reasonable security procedures and practices.” As our customers, including California residents, generally provide information to us that is covered by this definition of personal information in connection with their purchases via our website, our business has been affected by these new laws. As a result, we will need to ensure that all computerized data containing the previously-described personal information is sufficiently encrypted or that we have implemented appropriate measures to protect the integrity and security of that information and to notify our California customers of any unauthorized access or misappropriation. In addition, the code section requiring us to implement and maintain “reasonable security procedures and practices” provides no guidelines as to what may be deemed reasonable but leaves that determination to future court cases. This introduces a considerable measure of uncertainty to our compliance efforts. Such measures will likely increase the costs of doing business and, if we fail to implement appropriate safeguards or we fail to detect and provide prompt notice of unauthorized access as required by the new law, we could be subject to potential claims for damages and other remedies available to California residents whose information was improperly accessed or, under certain circumstances, the State of California could seek to enjoin our business operations until appropriate corrective actions have been taken. While we intend to comply fully with this law, we cannot assure you that we will be successful in avoiding all potential liability or disruption of business resulting from this law. If we were required to pay any significant amount of money in satisfaction of claims under this law, or any similar law enacted by another jurisdiction, or if we were forced to cease our business operations for any length of time as a result of our inability to comply fully with any such law, our business, operating results and financial condition could be adversely affected. Further, complying with the applicable notice requirements in the event of a security breach could result in significant costs.
Further, federal and state laws place restrictions on email marketing that could make it more difficult for us to acquire new customers, or to obtain repeat purchases from prior customers through inexpensive electronic marketing methods. The federal CAN-SPAM Act, for example, requires every commercial e-mail message to include an “opt-out” mechanism and requires all senders to comply with their recipients “opt out” requests. It also requires senders to label all commercial e-mail messages as advertisements or solicitations. These requirements may reduce the effectiveness of our e-mail marketing activities. If any current or future law requires us to eliminate or curtail our email marketing efforts, our ability to obtain new customers and increase revenues could be adversely affected or we could incur greater marketing costs, either of which could harm our business. While we intend to comply with applicable law regarding email marketing, there is no assurance that we will not incur fines or other liability as a result of an inadvertent violation of such a law. In addition, because our website is accessible over the Internet in multiple states and other countries, we may be subject to their laws and regulations or may be required to qualify to do business in those locations. We are qualified to do business only in California and Ohio at present. Our failure to qualify in a state or country where we are required to do so could subject us to taxes and penalties and we could be subject to legal actions and liability in those jurisdictions. The restrictions or penalties imposed by, and costs of complying with, these laws and regulations could harm our business, operating results and financial condition. Our ability to enforce
contracts and other obligations in states and countries in which we are not qualified to do business could be hampered, which could have a material adverse effect on our business. Further, an important aspect of the new Internet-focused laws is that where federal legislation is absent, states have begun to enact consumer-protective laws of their own and these can vary significantly from state to state (and country to country). Thus, it is difficult for any company to be sufficiently aware of the requirements of all applicable state laws and it is also difficult or impossible for any company to comply fully with the sometimes inconsistent standards and requirements set by various states. In addition to the consequences that could result from violating one or more state laws (or the laws of any other country), the costs of attempting to comply could be considerable.
Laws or regulations relating to privacy and data protection may adversely affect the growth of our Internet business or our marketing efforts.
We are subject to increasing regulation relating to privacy and the use of personal user information. For example, we are subject to various telemarketing laws that regulate the manner in which we may solicit future suppliers and customers. Such regulations, along with increased governmental or private enforcement, may increase the cost of growing our business. California has enacted several new laws that require all commercial website operators that collect personal information about California residents to adopt and post a privacy policy that meets certain specified criteria. Any failure to comply with this new law could subject us to civil penalties, injunctions, and/or lawsuits. As mentioned above, California enacted new sections of its Civil Code that require companies maintaining personal information about California residents to take reasonable measures to protect against identity theft and other unauthorized uses of such information and to notify California residents in the event that such information has been (or is likely to have been) misappropriated, inappropriately modified or destroyed. The new laws provide no standards for satisfactory compliance, so it is impossible to know for certain what steps the Company needs to take to comply with them. Compliance could require the Company to implement procedures that would require it to change the way it does business and such procedures may be expensive. In addition, several other states have enacted or proposed legislation that would limit the uses of personal user information gathered online or require online services to establish privacy policies. The Federal Trade Commission has adopted regulations regarding the collection and use of personal identifying information obtained from children under 13 years of age. Bills proposed in Congress would extend online privacy protections to adults. Moreover, legislation in the United States and existing laws in other countries require companies to establish procedures to notify users of privacy and security policies, obtain consent from users for collection and use of personal information, and/or provide users with the ability to access, correct and delete personal information stored by companies. These data protection regulations and enforcement efforts may restrict our ability to collect demographic and personal information from users, which could be costly or harm our marketing efforts. Further, any violation of privacy or data protection laws and regulations may subject us to fines, penalties and damages and may otherwise have a material adverse effect on our business, results of operations and financial condition.
We may be subject to liability for the content that we publish.
As a publisher of catalogs and online content, we face potential liability for defamation, negligence, intellectual property infringement, or other claims based on the information and other content contained in our catalogs and website. In the past, parties have brought these types of claims and sometimes successfully litigated them against online services. If we incur liability for our catalog or online content, our financial condition could be affected adversely and our reputation could suffer.
Our directors, executive officers and significant stockholders hold a substantial portion of our stock, which may lead to conflicts with other stockholders over corporate transactions and other corporate matters.
Our directors, executive officers and current beneficial holders of 5% or more of our outstanding common stock own a significant portion of our stock. These stockholders, acting together, are able to control or influence significantly all matters requiring stockholder approval, including the election of directors and significant corporate transactions such as mergers or other business combinations. This control may delay,
deter or prevent a third-party from acquiring or merging with us and limit the ability of smaller stockholders to influence corporate matters.
Exploration of strategic opportunities could disrupt our operations and cause us to incur significant expenses.
We recently engaged WR Hambrecht & Co as a financial advisor to assist our management team in exploring strategic alternatives to maximize stockholder value, including, but not limited to, the possible sale to, or merger of the business with, another entity offering strategic opportunities for growth of our business. However, there can be no assurance that the exploration of strategic alternatives will result in any transaction. Further, our engagement of a financial advisor, the exploration and evaluation of strategic opportunities and the work involved in any transaction that could result therefrom may distract our relatively lean management team from their day-to-day responsibilities, could disrupt the operation of our business and could cause us to incur significant expenses, including without limitation payments to advisors and service providers and expenses associated with holding any required meeting of stockholders and seeking requisite stockholder consent in connection with any such potential transaction, any of which could adversely affect our business, financial condition and operating results.
Item 1B.
Item 1B.
Unresolved Staff Comments
None.
Item 2.
Item 2.
Properties
As of April 2, 2006, we leased approximately 28,000 square feet of office space in San Francisco, California for our corporate headquarters. Also, as of April 2, 2006, we leased approximately 240,000 square feet for our fulfillment and distribution center located in Lockbourne, Ohio and approximately 13,000 square feet for our customer sales and service center located in San Diego, California. The lease term for our fulfillment and distribution center expires in July 2006 and we currently intend to execute a one year extension to this lease. We believe these facilities will be sufficient for our needs for at least the next twelve months, although we can offer no assurances in this regard. For a discussion of risks related to our facilities, see “Item 1A - Risk Factors.”
Our information technology systems are housed in a leased third-party facility in San Francisco, California which was moved from Santa Clara, California in July of 2005. Data is stored in a database that runs on a redundant server and storage array. We also have standby servers that can provide additional capacity as necessary. The facility hosting our servers provides redundant heating, ventilation, air conditioning, power and Internet connectivity. The redundant data center that we had in Cincinnati, Ohio is in the process of being eliminated. We currently plan to establish a failover system at our primary data center for all of our production systems during the second quarter of fiscal 2007, although we currently believe that this will not occur prior to the elimination of the Cincinnati, Ohio facility. There can be no assurances that we will accomplish this task in this timeframe or at all. For a discussion of the risks related to disruption in services at our third-party facility in San Francisco and Ohio and other facility-related risks, see “Item 1A - Risk Factors.”
Item 3.
Item 3.
Legal Proceedings
From time to time, the Company is subject to legal proceedings and claims in the ordinary course of business, including claims of alleged infringement of trademarks and other intellectual property rights. The Company is not currently aware of such legal proceedings or claims that it believes will have, individually or in the aggregate, a material adverse effect on its financial position or results of operations.
Item 4.
Item 4.
Submission of Matters to a Vote of Security Holders
There were no matters submitted to a vote of security holders during the fourth quarter of the 2006 fiscal year.
PART II
Item 5.
Item 5.
Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities
Our common stock began trading on the Nasdaq National Market System on September 25, 2003 under the symbol REDE. The following table sets forth the high and low closing prices for the periods indicated.
On June 21, 2006, the closing sales price of our common stock on the Nasdaq National Market System was $9.99.
On September 24, 2003, a Registration Statement on Form S-1 (Commission File No. 333-106120) relating to our initial public offering was declared effective by the Securities and Exchange Commission. The net proceeds to us from the offering were approximately $29.0 million after deducting underwriting discounts of $1.8 million. We used approximately $1.5 million of the net proceeds for fees related to the offering (excluding banker fees). Since the initial public offering, we have used approximately $9.3 million for purchases of property and equipment. We have used and continue to use the net proceeds to fund our working capital requirements throughout the year.
Stockholders
The number of stockholders of record as of June 21, 2006 was approximately 267. This number excludes beneficial owners whose stock is held in nominee or street name.
Dividend Policy
We have never declared nor paid, and do not currently intend to pay, a cash dividend on our common stock. We currently expect to retain future earnings, if any, for use in the operation and expansion of our business and do not anticipate paying any cash dividends in the foreseeable future. Our loan and security agreement contains a covenant that prohibits us from paying cash dividends, see also “Item 7 - Management’s Discussion and Analysis of Financial Condition and Results of Operations - Liquidity and Capital Resources.”
Equity Compensation Plan Information
The information required by this Item regarding equity compensation plans will be set forth in the section with the caption “Equity Compensation Plan Information” in our definitive proxy statement. This information is incorporated herein by reference.
Item 6.
Item 6 of Part II, “Selected Financial Data” and Item 8 of Part II, “Financial Statements and Supplementary Data.”
Forward-Looking Statements
This report, together with the documents incorporated herein by reference, contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities and Exchange Act of 1934, as amended, including without limitation projections regarding future performance. Such statements are based upon current expectations and involve risks and uncertainties. Any statements contained in this report that are not purely statements of historical fact may be deemed to be forward-looking statements. Such forward-looking statements may include but are not limited to statements regarding our future operations and enhancements, product offerings, business, financial condition, results of operations and prospects. Additionally, statements concerning possible changes in applicable rules or legislation are forward-looking statements. Words such as “expects,” “anticipates,” “intends,” “plans,” “believes,” “seeks,” “estimate,” “may,” “might,” “should,” “would,” “could” and similar expressions or variations of such words are intended to identify forward-looking statements, but are not the exclusive means of identifying forward-looking statements in this report. All forward-looking statements in this report are based upon information available to us as of the date hereof, and we assume no obligation to revise or update any such forward-looking statements in order to reflect any event or circumstance that may arise after the date of this report. Actual results and the timing of certain events could differ materially from our current expectations. Factors that could cause or contribute to such differences include, but are not limited to, those set forth above in this report under “Item 1A - Risk Factors,” and elsewhere in this report, and those contained from time to time in our other filings with the SEC. We caution investors that our business and financial performance are subject to substantial risks and uncertainties.
Overview
RedEnvelope is a branded online retailer of upscale gifts, dedicated to helping its predominantly female customers celebrate and nurture their most important relationships with unique gifts and unequalled gift-giving experiences. RedEnvelope offers an extensive and fresh collection of imaginative and original gifts through our catalog, web store and phone store. Our in-house design team creates unique proprietary products, and our merchants source unique products domestically and from various parts of the world and often commission artists and vendors to create exclusive gifts. Through our web store, www.redenvelope.com, customers can search for gifts by recipient, occasion, gift category and price point. We also publish our full-color catalog several times a year.
The fiscal year 2006 was a 52-week year and fiscal year 2005 was a 53-week year. In fiscal year 2006, our net revenues increased 11.6% from $101.4 million in fiscal year 2005 to $113.2 million. Our net loss for fiscal 2006 was $5.6 million compared to $5.2 million in the prior fiscal year. We increased our circulation of catalogs in fiscal 2006 by 19.3% and experienced growth of 10.5% in revenues from customers who received our catalogs or emails. In fiscal 2006, online revenue grew 23.6% through our various search and affiliate sources. Our customer file grew 24.7% in fiscal 2006 to 2.9 million names. The only area of revenue decline was the revenues from customers that order directly through our web store without any apparent connection to one of our marketing programs.
While we achieved revenue growth of 11.6% in fiscal 2006 and shipped orders grew 10.1%, our average revenue per order only increased 1.4% reflecting the impact of discounted shipping offered during the holiday season, as well as a shift in product mix. This resulted in a slight decrease in gross margins from 52.0% in fiscal year 2005 to 51.2% in fiscal 2006. In fiscal 2007, we will be focusing on improving our shipping margins in an effort to increase our overall gross margin percent.
Our fulfillment expenses as a percentage of net revenues decreased from 15.4% in fiscal 2005 to 14.2% in fiscal 2006 due to improved efficiencies in warehouse management, as well as our ability to leverage fixed costs across higher net revenues.
Marketing spending focused on increased online marketing and catalog campaigns, public relations and market research, and reduced outdoor and print advertising campaigns in fiscal 2006. This resulted in a slight increase in dollars however marketing expenses as a percentage of net revenues decreased from 24.1% in fiscal 2005 to 23.2% in fiscal 2006.
Our general and administrative expenses increased in dollars and as a percentage of net revenues primarily due to leadership transition costs of $1.5 million which were incurred in the fourth quarter of 2006, as well as increased personnel and recruiting costs over the prior fiscal year.
For fiscal year 2007, we intend to achieve realistic growth by focusing our attention on the relationship-building essence of gift-giving, simplifying our business, and executing with excellence. We also currently plan to evaluate and test new off-line and on-line channels for efficient new customer acquisitions. We currently believe that continued focus in these areas will allow us to demonstrate and build a stable operational and financial foundation that will enable us to achieve a loss for fiscal year 2007 of approximately $2.0 million to $2.5 million. This projection includes our current estimate that the adoption of SFAS 123(R) will result in stock option compensation expenses of approximately $2.0 million to $2.5 million in fiscal year 2007, although actual results may differ due to differences and changes in components of the expense calculation during the fiscal year. For discussion of the requirements of SFAS 123(R), see “Recently Issued Accounting Standards” below under this Item 7
Item 7A.
Quantitative and Qualitative Disclosures About Market Risk
Interest Rate Risk We currently maintain a portfolio of fixed and variable investments consisting of cash equivalents, short-term marketable securities and long-term marketable securities, which can be affected by changes in market interest rates. The objective of our investment activities is to preserve principal, while at the same time maximizing yields without significantly increasing risk. To achieve this objective, we invest in highly liquid, investment grade and government debt securities. Our investments in debt securities are subject to interest rate risk. According to our investment policy, we may invest in taxable and tax exempt instruments. In addition, the policy establishes limits on credit quality, maturity, issuer and type of instrument. Marketable securities are classified as “available for sale”. Marketable securities are comprised of government securities and corporate bonds. We do not use derivative financial instruments in our investment portfolio. (See Note 3 of Notes to Financial Statements)
All highly liquid investments with maturity of three months or less at the date of purchase are considered to be cash equivalents. The remaining investments in marketable securities are considered short-term investments if original maturities range over three months but less than one year.
The following table lists our cash and cash equivalents and short-term investments at April 2, 2006:
If interest rates changed adversely by 100 basis points, our results from operations and cash flows would not be materially affected.
Foreign Currency Risk We purchase a significant amount of inventory from vendors outside of the U.S. in transactions that are generally denominated in U.S. dollars. As of April 2, 2006, any currency risks related to these transactions were not significant to us. A decline in the relative value of the U.S. dollar to other foreign currencies could, however, lead to increased purchasing costs.
Item 8.
Item 8.
Financial Statements and Supplementary Data
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Board of Directors and Stockholders of
RedEnvelope, Inc.:
We have audited the accompanying balance sheets of RedEnvelope, Inc. (the “Company”) as of April 2, 2006 and April 3, 2005, and the related statements of operations, stockholders’ equity/ (deficit), and cash flows for each of the three years in the period ended April 2, 2006. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. Our audits included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, such financial statements present fairly, in all material respects, the financial position of RedEnvelope, Inc. as of April 2, 2006 and April 3, 2005, and the results of its operations and its cash flows for each of the three years in the period ended April 2, 2006, in conformity with accounting principles generally accepted in the United States of America.
/s/ DELOITTE & TOUCHE LLP
San Francisco, California
June 29, 2006
RedEnvelope, Inc.
BALANCE SHEETS
See accompanying notes to these financial statements.
RedEnvelope, Inc.
STATEMENTS OF OPERATIONS
See accompanying notes to these financial statements.
RedEnvelope, Inc.
STATEMENTS OF STOCKHOLDERS’ EQUITY (DEFICIT)
[Additional columns below]
[Continued from above table, first column(s) repeated]
See accompanying notes to these financial statements.
RedEnvelope, Inc.
STATEMENTS OF CASH FLOWS
See accompanying notes to these financial statements.
RedEnvelope, Inc.
NOTES TO FINANCIAL STATEMENTS
1.
Summary of Significant Accounting Policies
Description of Business - RedEnvelope, Inc. (the “Company”) is a branded online retailer of upscale gifts. The Company offers an extensive and fresh collection of imaginative, original gifts through its web store and also publishes full-color catalogs several times during the year. The Company operates as a single business segment.
Fiscal Year - The Company’s fiscal year ends on the Sunday closest to March 31, based on a 52/53-week year. Fiscal year 2005, which ended on April 3, 2005, was a 53-week period. Fiscal years 2006 and 2004, both 52-week periods, ended on April 2, 2006 and March 28, 2004, respectively.
Use of Estimates - The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities as of the date of the financial statements and reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates and such differences could affect the results of operations reported in future periods. Our significant accounting policies are set forth below.
Cash Equivalents - The Company considers all highly liquid investments purchased with an original or remaining maturity of three months or less to be cash equivalents.
Short-term Investments - The Company’s Short-term Investments are considered available-for-sale securities, as defined by the Statement of Financial Accounting Standards (“SFAS”) No. 115, “Accounting for Certain Investments in Debt and Equity Securities.” The Company’s investment objectives include: preserving principal, meeting liquidity needs, delivering yields in relationship to risk tolerance and market conditions, avoiding inappropriate concentrations of investments, and providing direct fiduciary control of all cash and investments. Unrealized short-term investments gains and losses are reflected as a net amount under the caption of accumulated other comprehensive loss within the statements of stockholders’ equity/(deficit). Realized gains and losses are recorded within the statements of operations. For the purpose of computing realized gains and losses, cost is identified on a specific identification basis.
Concentration of Credit Risk - Financial instruments that potentially subject the Company to a concentration of credit risk consist of cash, cash equivalents, marketable debt securities and accounts receivable. Cash and cash equivalents are deposited with high credit quality financial institutions. The Company’s accounts receivable are generally derived from credit card purchases from customers and are typically settled within two to three days.
Allowance for Doubtful Accounts - The Company reviews the aging of its accounts receivable balances to specifically identify accounts for uncollectibility.
Inventory. Inventories consist of acquired finished goods for resale. Inventories are stated at the lower of cost or market with costs based on the first-in-first-out method. The Company estimates a provision for damaged, obsolete, excess and slow-moving inventory based on inventory aging reports and specific identification. Specific provisions are recorded in the event the cost of the inventory exceeds the fair market value. In addition, we estimate a reserve for expected inventory shrinkage based on historical shrinkage factors and our current inventory levels. Actual shrinkage is recorded at year-end based on the results of our physical inventory count. The inventory reserves were $1.4 million and $0.8 million as of April 2, 2006 and April 3, 2005, respectively.
Prepaid Catalog Costs - Prepaid catalog costs consist of third-party costs including paper, printing, postage, production and mailing costs for all Company direct response catalogs. These costs are capitalized as prepaid catalog costs and are amortized over their expected period of future benefit which generally does not exceed three months. This amortization is based upon the portion of actual revenues to the total of actual and estimated future revenues on an individual catalog basis. Prepaid catalog costs are evaluated for realizability at
RedEnvelope, Inc.
NOTES TO FINANCIAL STATEMENTS - (Continued)
each reporting period. If the carrying amount is in excess of the estimated probable remaining future net benefit of the catalog, the excess is expensed in the reporting period. At April 2, 2006 and April 2, 2005, the Company had prepaid catalog costs of $1.4 million and $2.1 million, respectively, recorded as prepaid catalog costs and other current assets.
Property and Equipment - Property and equipment, including leasehold improvements, are stated at historical cost, less accumulated depreciation and amortization. Depreciation and amortization are computed using the straight-line method over the estimated useful lives of these assets, ranging from three to seven years, or, in the case of leasehold improvements, over the lease period or estimated useful life, whichever is shorter.
Capitalized Software and Website Development Costs - The Company capitalizes internally developed software costs and website development costs in accordance with the provisions of Statement of Position (“SOP”) 98-1, Accounting for Costs of Computer Software Developed or Obtained for Internal Use and Emerging Issues Task Force (“EITF”) No. 00-2, Accounting for Website Development Costs. Capitalized costs are amortized on a straight-line basis over the useful life of the software once it is available for use.
Valuation of Long-Lived Assets - Long-lived assets held and used by the Company are reviewed for impairment whenever events or changes in circumstances indicate the net book value may not be recoverable. An impairment loss is recognized if the sum of the expected future cash flows from use of the asset is less than the net book value of the asset. The amount of the impairment loss will generally be measured as the difference between net book values of the assets and their estimated fair values. Our estimate of undiscounted future cash flows is based upon our experience, historical operations, estimates of future profitability and economic conditions.
Revenue recognition - The Company derives revenues from product sales to consumers and businesses. Generally, payment by credit card is required prior to shipment. The Company’s policy is to recognize revenue on the date on which the product has been received by the customer, and defer any payments received prior to the date on which the customer has received the goods. The Company uses third-party freight carrier information as a basis for determining when delivery has occurred.
Revenues are recorded net of estimated returns, coupons redeemed by customers, and other discounts. The Company’s policy is to record a sales return allowance for anticipated future returns in the period of sale. The Company generally does not extend credit to customers, except through third-party credit cards and for Business Gifts Services corporate customers.
Shipping and Handling Costs - Shipping costs, which include inbound and outbound freight costs and the cost of gift wrap, are included in Cost of Sales. Handling costs, which include fulfillment center expenses, are included in Operating Expenses - Fulfillment. Handling costs included in Operating Expenses - Fulfillment for the fiscal years ended April 2, 2006, April 3, 2005 and March 28, 2004 were $6.9 million, $6.7 million and $4.6 million, respectively. The Company’s gross profit may not be comparable to other entities, which may allocate all shipping and handling costs to either cost of sales, resulting in lower gross profit, or to operating expenses, resulting in higher gross profit.
Provision for Sales Returns and Allowances - The provision for sales returns and allowances consists of our estimates of potential future product returns related to current period revenue. Management analyzes historical returns, current economic trends and changes in customer demand and acceptance of our products when evaluating the adequacy of the sales returns and allowances. Significant management judgments and estimates must be made and used in connection with establishing the sales returns and allowances in any accounting period. Actual returns may differ materially from our estimated reserve, which could adversely affect our operating results and financial condition in future periods.
RedEnvelope, Inc.
NOTES TO FINANCIAL STATEMENTS - (Continued)
A summary of changes in the Reserve for Sales Returns and Allowances is as follows:
Advertising Expense - The Company expenses the costs of producing advertisements at the time production occurs and expenses the cost of communicating advertising in the period in which the advertising space or airtime is used. Internet advertising expenses are recognized either in accordance with the actual number of clicks-through to the RedEnvelope website or on a straight-line basis over the term of the contract. Advertising expenses, excluding catalog costs, for fiscal years 2006, 2005, and 2004 were $8.3 million, $10.3 million and $6.9 million, respectively, and were included in marketing expenses.
Income Taxes - The Company accounts for income taxes under the asset and liability approach whereby the expected future tax consequences of temporary differences between the book and tax basis of assets and liabilities are recognized as deferred tax assets and liabilities. A valuation allowance is established for any deferred tax assets for which realization is uncertain.
Stock-Based Compensation - The Company accounts for stock-based employee compensation arrangements in accordance with provisions of Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees (“APB No. 25”), and complies with the disclosure provisions of SFAS No. 123, Accounting for Stock-Based Compensation (“SFAS No. 123”). Under APB No. 25, compensation cost is recognized based on the difference, if any, between the fair market value of the Company’s stock on the date of grant and the amount an employee must pay to acquire the stock. Equity instruments issued to non-employees are accounted for in accordance with the provision of SFAS No. 123 and Emerging Issues Task Force Issue No. 96-18.
Had compensation cost for the Company’s stock options been determined based on the fair value of the options at the date of grant for options granted in fiscal years 2006, 2005 and 2004 consistent with the provisions of SFAS No. 123 the Company’s pro forma net loss would have been as follows:
RedEnvelope, Inc.
NOTES TO FINANCIAL STATEMENTS - (Continued)
In March 2006, the Company granted 200,000 shares of restricted stock awards to the Chief Executive Officer. The market price of the underlying common stock on the date of grant was initially recorded as deferred compensation within the stockholders’ equity section of the Company’s balance sheet and subsequently is being amortized over the expected service period. As of April 2, 2006, $0.5 million of compensation expense was amortized, representing the 25% vesting upon issuance, and is included in general and administrative expense.
Loss Per Share - For all periods presented, basic net loss per share equals diluted net loss per share because the effect of stock equivalents (stock options and warrants outstanding) would have been antidilutive. The weighted average number of stock options and warrants outstanding excluded from the calculation for fiscal years 2006, 2005 and 2004 were approximately 1.5 million, 1.4 million and 1.3 million, respectively.
Comprehensive Loss - Comprehensive loss consists of two components, net loss and other comprehensive income (loss). Other comprehensive income (loss) refers to revenue, expenses, gains and losses that under generally accepted accounting principles are recorded as an element of stockholders’ equity but are excluded from net income (loss).
New Accounting Pronouncements - In December 2004, the FASB issued SFAS No. 123 (Revised 2004), “Share-Based Payment” (“SFAS 123(R)”). This statement replaces FASB Statement No. 123, “Accounting for Stock-Based Compensation,” and supersedes APB Opinion No. 25, “Accounting for Stock Issued to Employees.” SFAS 123(R) requires all companies to measure compensation cost for all share-based payments, including stock options, at fair value. Under the terms of SFAS 123(R), the fair value of any equity award will be estimated at the grant date and this fair value will be recognized as compensation cost over the service period for all awards that are subject to a vesting period. SFAS 123(R) requires that fair value be estimated using an option pricing model that takes into account at least the following items - the exercise price, the expected term of the option, the current price of the underlying share, the expected volatility of the price of the underlying share, the expected dividends on the underlying share and the risk free rate of interest. Upon adoption of SFAS 123(R), compensation cost will be recognized for any unvested awards that were granted prior to the date of adoption using the same estimate of the grant-date fair value used to determine the pro forma disclosures under SFAS 123. The statement is effective for the Company at the beginning of fiscal 2007 and the adoption of SFAS 123(R) will result in an anticipated increase in equity compensation expense of approximately $2.0 million to $2.5 million in fiscal 2007. However, actual results may differ due to differences and changes in components of the calculation during the 2007 fiscal year.
In March 2005, the FASB issued FASB Interpretation No. (“FIN”) 47, “Accounting For Conditional Asset Retirement Obligations - An Interpretation of FASB Statement No. 143”, which requires an entity to recognize a liability for the fair value of a conditional asset retirement obligation when incurred if the liability’s fair value can be reasonably estimated. We adopted the provisions of FIN 47 as of the end of fiscal 2006. The adoption of this Interpretation did not have an impact on our consolidated financial position, results of operations or cash flows.
Reclassifications - Certain items in the prior year’s financial statements have been reclassified to conform to the fiscal 2006 presentation.
2.
Initial Public Offering
On September 30, 2003, the Company completed its initial public offering, whereby the Company sold 2.2 million shares of common stock at $14 per share and received proceeds of approximately $29.0 million (after underwriters’ discounts of $1.8 million). Total related offering expenses were approximately $1.5 million (excluding underwriter’s discounts).
On September 30, 2003, the Company’s outstanding Preferred Stock was automatically converted into approximately 6.0 million shares of common stock. Each share of Series A and B preferred stock outstanding
RedEnvelope, Inc.
NOTES TO FINANCIAL STATEMENTS - (Continued)
was converted into common stock on a one-for-one exchange ratio of common for preferred. Each share of Series C, D, E, and F preferred stock outstanding was converted into common stock on an exchange ratio of one share of preferred for approximately 1.58, 1.80, 1.27 and 0.99 shares of common, respectively.
3.
Investments
All of the Company’s investments are considered available-for-sale. Available-for-sale investments are recorded at fair market value, with unrealized gains or losses included in accumulated other comprehensive income. As of April 2, 2006, there were no unrealized gains or losses related to available-for-sale short-term investments. Short-term investments are comprised of auction rate securities with an auction maturity of three months or less but an underlying long-term maturity and government securities and corporate bonds both with original maturities beyond three months but less than one year.
Available-for-sale investments at April 2, 2006 and April 3, 2005 were as follows (in thousands):
There were no realized gains or losses the fiscal year ended April 2, 2006, April 3, 2005 and March 28, 2004.
4.
Property and Equipment
Property and equipment consists of the following (estimated useful life):
The cost of property and equipment under capital leases was $2.4 million and $2.8 million at April 2, 2006 and April 3, 2005, respectively. Accumulated depreciation for assets under capital leases was $2.0 million and $1.8 million, at April 2, 2006 and April 3, 2005, respectively.
RedEnvelope, Inc.
NOTES TO FINANCIAL STATEMENTS - (Continued)
5.
Income Taxes
The Company has not recorded a tax benefit in any period presented due to losses incurred and uncertainty of realizing the net operating loss carryforwards. A reconciliation of the statutory federal income tax rate with the Company’s effective income tax rate is as follows:
Deferred tax assets are summarized as follows:
The Company believes that, based on a number of factors, the available objective evidence creates sufficient uncertainty regarding the realizability of the deferred tax assets such that a full valuation allowance has been recorded. A valuation allowance is provided when it is more likely than not that some portion of the deferred tax asset will not be realized. The Company established a 100% valuation allowance at April 2, 2006 and April 3, 2005 due to the uncertainty of realizing future tax benefits from its net operating loss carryforward and other deferred tax assets.
At April 2, 2006, the Company had net operating loss carryforwards for federal income tax purposes of approximately $81.5 million that are due to expire beginning in fiscal year 2020 through fiscal 2027. State net operating loss carryforwards are approximately $31.5 million that are due to expire beginning in fiscal year 2009 through fiscal 2017. Under the Internal Revenue Code of 1986, as amended, the amounts of and benefits from net operating loss and tax carryforwards may be impaired or limited in certain circumstances. Events which could cause limitations in the amount of net operating losses that the Company may utilize in any one year include, but are not limited to, a cumulative ownership change of more than 50%, as defined, over a three year period. The Company’s preferred stock issuances created an ownership change of more than 50% which caused annual limitations in the amount of net operating losses that arose prior to such ownership change that the Company may utilize for both federal and state purposes. In addition, the Company’s initial public offering and/or changes in its stock ownership since its initial public offering may have caused further ownership changes and may result in additional annual limitations in the amount of its federal and state net operating losses that the Company may utilize.
6.
Borrowing Arrangements
As of April 2, 2006, the Company had a line of credit from a lender which expired on June 13, 2006. As of April 2, 2006 and April 3, 2005, the Company did not have any outstanding borrowings under this credit facility.
RedEnvelope, Inc.
NOTES TO FINANCIAL STATEMENTS - (Continued)
On June 26, 2006, the Company signed a loan and security agreement with a lender that provides for a senior secured revolving credit facility in an amount equal to the lesser of $12.5 million or an amount determined under a borrowing base formula. The borrowing base formula is determined by the sum of the appraised net retail liquidation value of eligible inventory, eligible credit card accounts receivable, less applicable reserves. As of June 26, 2006, the borrowing base reflected an availability of $7.0 million. Interest will accrue on amounts borrowed under the credit facility at the prime lending rate or a LIBOR rate plus an applicable margin. The loan and security agreement provides for certain events of default, sets forth affirmative and negative covenants, including without limitation certain financial covenants, to which the Company must adhere and expires in June 2010. Borrowings will be secured by a first priority interest in all of the Company’s assets, tangible and intangible, and proceeds realized from the sale or other disposition thereof.
7.
Commitments and Contingencies
Leases - The Company leases office space and equipment under noncancelable operating and capital leases with various expiration dates through 2010. Rent expense for the fiscal years 2006, 2005 and 2004 was approximately $1.6 million, $1.8 million, and $1.9 million, respectively. Future minimum lease payments under noncancelable operating and capital leases as of April 2, 2006 are as follows:
Legal Proceedings - From time to time, the Company is subject to legal proceedings and claims in the ordinary course of business, including claims of alleged infringement of trademarks and other intellectual property rights. The Company is not currently aware of such legal proceedings or claims that it believes will have, individually or in the aggregate, a material adverse effect on its financial statements.
8.
Stock Option and Benefit Plans
In March 2006, the Company granted 200,000 shares of restricted stock awards to the Chief Executive Officer. The market price of the underlying common stock on the date of grant was initially recorded as deferred compensation within the stockholders’ equity section of the Company’s balance sheet and subsequently is being amortized over the expected service period. As of April 2, 2006, $0.5 million of compensation expense was amortized, representing the 25% vesting upon issuance, and is included in general and administrative expense.
In March 2006, the Company granted 125,000 common stock options to the Chief Operating Officer. The exercise price of these options is $9.56, and they will vest 25% six months after the commencement of his employment with the Company and as to 1/42 of the balance of the shares each month thereafter for so long as he is employed by the Company.
RedEnvelope, Inc.
NOTES TO FINANCIAL STATEMENTS - (Continued)
Neither of these grants were made pursuant to one of the Company’s equity compensation plans.
1999 Stock Option Plan
The Company maintains a stock option plan, as amended (the “1999 Plan”), which authorizes the Board of Directors to grant incentive stock options and nonstatutory stock options to employees, directors and consultants. The maximum aggregate number of shares that may be granted under the Plan is 2,228,864 shares of common stock, plus an annual increase on the first day of each of the Company’s fiscal years beginning in each of 2005 through 2009 equal to the lesser of (a) 426,985 shares, (b) 4% of the shares outstanding on the last day of the immediately preceding fiscal year, or (c) such lesser number of shares as the Board shall determine; provided however that the maximum number of shares that may be added in any year pursuant to this sentence shall not result in the 1999 Plan’s having available for issuance an aggregate number of shares that exceeds 4% of the fully diluted shares of outstanding common stock as of the last day of the immediately preceding fiscal year.
Generally, options vest 25% on the first anniversary of the date of grant and thereafter become exercisable in equal monthly installments over the remaining 36 months. Options are exercisable for a term of ten years after the date of grant. No options will be granted to any individual who owns more than 10% of total combined voting power of all classes of stock.
The 1999 Plan also provides for early exercise of options prior to vesting. Any unvested shares purchased are subject to repurchase by the Company upon occurrence of certain events or conditions, such as employment termination, at the original purchase price. As of April 2, 2006 and April 3, 2005, there were no shares outstanding subject to repurchase rights under the 1999 Plan.
In fiscal year 2004, the Company granted approximately 0.3 million options to employees at an exercise price that was less than the fair market value of the Company’s stock on the date of grant. The Company recorded $0.7 million of deferred compensation related to these option grants, which is included as a separate component of stockholders’ equity, and is being amortized over the vesting period of the awards. The Company recorded compensation expense of $10,000, $24,000 and $130,000 in fiscal years 2006, 2005 and 2004, respectively which is included in general and administrative expenses in the statements of operations.
Directors Stock Option Plan
The Directors Stock Option Plan is intended to be a formula award plan providing for the grant of nonstatutory stock options to non-employee members of our Board of Directors. Initial option grants vest 25% on each of the first four anniversaries of the date of grant, and annual option grants vest 100% on the first anniversary of the grant date.
The Company registered 449,615 shares of $0.01 par value common stock for the Directors Stock Option Plan.
RedEnvelope, Inc.
NOTES TO FINANCIAL STATEMENTS - (Continued)
The following table summarizes activity under the Company’s stock option plans:
The following table summarizes information about stock options outstanding under the Company’s stock option plans at April 2, 2006:
RedEnvelope, Inc.
NOTES TO FINANCIAL STATEMENTS - (Continued)
The pro-forma disclosures required by SFAS No. 123 are included in Note 1. The fair value of each option grant is estimated on the date of grant using the Black-Scholes Method with the following weighted-average assumptions:
Employee Stock Purchase Plan (“ESPP”) - The ESPP allows employees to purchase common stock at a discount to market price through payroll deductions. The plan is structured through a series of consecutive six-month offering periods. Except for the first offering period, these offering periods generally start on the first trading day on or after May 1st and November 1st of each year and end, respectively, on the last trading day of the next October and April. The Company registered 401,366 shares $0.01 par value common stock for the ESPP. During fiscal year 2006, the Company issued 17,917 shares stock under the ESPP.
401(k) Savings Plan - The Company sponsors a 401(k) Savings Plan which allows all employees to make salary deferral contributions ranging from 1% to 15% of their eligible earnings. The Company can make discretionary matching contributions to the Plan. During fiscal years 2006, 2005, and 2004, the Company contributed $95,000, $98,000 and $66,000, respectively, to the Plan.
9.
Related Party Transactions
Notes receivable from stockholders represent amounts owed to the Company from the exercise of stock options. These full recourse notes are collateralized by common stock and bear interest at a rate of 5.74% per annum. Interest and principal is due on July 20, 2007. At April 2, 2006 and April 3, 2005, notes receivable were approximately $44,000.
10.
Quarterly Financial Information (Unaudited)
The quarterly financial information presented below reflects all adjustments, which, in the opinion of management, are of a normal and recurring nature necessary to present fairly the results of operations for the periods presented.
RedEnvelope, Inc.
NOTES TO FINANCIAL STATEMENTS - (Continued)
(1)
The fourth quarter of 2005 includes an adjustment of $650,000 relating to prior periods, which decreased cost of goods sold, increased gross profit and decreased net loss. The out-of-period adjustment includes $321,000 associated with prior fiscal quarters in 2005 and $329,000 associated with prior years. The effect of the adjustment to any prior period would not be material.
Item 9.
Item 9.
Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
None.
Item 9A.
Item 9A.
Controls and Procedures
Disclosure Controls and Procedures - The Company evaluated the design and operation of its disclosure controls and procedures to determine whether they are effective in ensuring that the disclosure of required information is timely and made in accordance with the Exchange Act and the rules and forms of the Securities and Exchange Commission. This evaluation was made under the supervision and with the participation of management, including the Company’s principal executive officer and principal financial officer as of the end of the period being reported on in this Annual Report on Form 10-K. The Company continues to formalize and document procedures already in place. Maintenance of disclosure controls and procedures is an ongoing process and controls and procedures may change over time. The Company also has established a Disclosure Committee, which consists of certain members of the Company’s senior management. Based on this evaluation, our chief executive officer and our chief financial officer have concluded that our disclosure controls and procedures, as defined at Exchange Act Rules 13a-15(e) and 15d-15(e), are effective to ensure that information required to be disclosed by the Company in reports that it files under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in Securities and Exchange Commission rules and forms. During the last fiscal quarter, there have not been any changes to the Company’s internal control over financial reporting that have materially affected, or that are reasonably likely to materially affect, the Company’s internal control over financial reporting.
Item 9B.
Item 9B.
Other Information
On February 10, 2006, the Board of Directors approved an amendment to the employment agreements of Polly Boe, Gary Korotzer and Chris Nordquist that will provide them with the following benefits: 12 months of salary in the event of termination of employment following a change in control of the Company and 6 months of salary in the event of a voluntary resignation following a change in control of the Company. The Board of Directors also approved an amendment to the employment agreement of Frank Buettner that will provide him with 6 months of salary in the event of a voluntary resignation following a change in control of the Company. Mr. Buettner is already provided with certain change of control benefits in the event of the termination of his employment following a change in control of the Company under his existing agreement.
On January 31, 2006, the Board of Directors approved, and the Company has paid, additional compensation to Polly Boe, the Company’s Chief Financial Officer, and Christopher Nordquist, the Company’s General Counsel, for assuming additional management responsibilities associated with the recent leadership transitions. For the period beginning January 15, 2006 until March 12, 2006, Ms. Boe was paid additional cash compensation at a rate of $12,500 per month, and for the period beginning January 15, 2006 through the present time, Mr. Nordquist is being paid additional cash compensation at a rate of $5,000 per month. Mr. Nordquist will continue to receive this additional monthly amount until such time as the Compensation Committee determines that Mr. Nordquist is no longer assuming such additional management responsibilities. On such date, the Board of Directors also approved an increase to the base salaries to Polly Boe, Gary Korotzer and Chris Nordquist such that they each currently receive an annual base salary of $285,000.
On January 23, 2006, Kristine Dang, the Company’s Executive Vice President, Merchandising, resigned from the Company. In connection with her resignation, the Company and Ms. Dang entered into a Separation Agreement and General Release, dated January 23, 2006, which provides that the Company will pay Ms. Dang severance in the amount of $137,500 and for six months of her health care coverage in exchange for a general release of all claims against the Company. The foregoing description of the Separation Agreement and General Release is qualified in its entirety by reference to the provisions of the Separation and General Release attached as Exhibit 10.56 to this annual report of Form 10-K.
On May 11, 2006, the Compensation Committee of the Board of Directors approved a modification of Mr. Buettner’s employment offer letter dated February 10, 2006, pursuant to which Mr. Buettner’s reimburse-
ment allowances for relocation (including $30,000 for moving, $20,000 for travel and an unspecified amount for temporary housing until November 1, 2006), less amounts used through that date, were changed to cash stipends to be paid in equal monthly installments through December, 2006, less applicable taxes and withholding.
As disclosed in the 8-K dated January 23, 2006 filed by the Company on January 24, 2006, Alison L. May resigned from her positions as the President and Chief Executive Officer and as a director of the Company. As disclosed in the 8-K dated February 17, 2006 filed by the Company on February 23, 2006, Ms. May’s resignation became effective on February 21, 2006 upon the appointment of her successor, Ken Constable. In connection with Ms. May’s resignation, the Company and Ms. May entered into a Separation Agreement and General Release dated March 30, 2006, which provides that the Company will pay Ms. May severance payments totaling $285,000 and will pay twelve months of her and her dependents’ health insurance coverage in exchange for a general release of any claims against the Company. In addition, the agreement provides that Ms. May will provide certain consulting services to the Company through June 30, 2006 for which the Company will pay Ms. May a weekly retainer of $1,200 and at the rate of $150 an hour for each hour of service provided in excess of 8 hours per week. All unvested stock options held by Ms. May will continue to vest until the completion of such consulting relationship. The foregoing description of the Separation Agreement and General Release is qualified in its entirety by reference to the provisions of the Separation Agreement and General Release attached as Exhibit 10.57 to this annual report on Form 10-K.
On June 14, 2006, the Compensation Committee of the Board of Directors adopted the Company’s Fiscal 2007 Bonus Plan. The bonus plan provides for a bonus pool to be funded by 30% of the excess earnings of the Company’s fiscal 2007 results above a specified target subject to certain limitations and caps. The bonus plan provides that the bonus pool would be allocated among certain of the Company’s employees, including its executive officers, according to a system of target incentives, which are calculated as percentages of such employees’ base salaries and which increase with position levels. The foregoing description of the Fiscal 2007 Bonus Plan is qualified in its entirety by reference to the provisions of the Fiscal 2007 Bonus Plan attached as Exhibit 10.58 to this annual report on Form 10-K.
On June 26, 2006, the Company entered into a Loan and Security Agreement with Wells Fargo Retail Finance, LLC pursuant to which Wells Fargo Retail Finance, LLC will provide to the Company a revolving credit facility in a principal amount equal to the lesser of $12,500,000 or an amount that is equal to the aggregate of a percentage of the Company’s eligible credit card receivables plus the lesser of a percentage of the cost of the Company’s eligible inventory, net of inventory reserves, if any, or a percentage of the net retail liquidation value of the Company’s eligible inventory. Interest will accrue on amounts borrowed under the credit facility at the prime lending rate or a LIBOR rate plus an applicable margin. The Company’s obligations under the Loan and Security Agreement are secured by a security interest in substantially all of the tangible and intangible assets of the Company (the “Collateral”).
The Loan and Security Agreement sets forth certain affirmative covenants that require the Company to, among other things, maintain its insurance policies, maintain its properties and the Collateral in good order, pay its taxes, comply with applicable laws, keep accurate and proper books and records of Collateral, provide access to its records, provide monthly borrowing base certificates and monthly and annual financial reports, and cause the undertaking of certain inventories, appraisals and audits of the Collateral. The Loan and Security Agreement also contains negative covenants that limit the ability of the Company, except as set forth therein, to, among other things, enter into or materially amend (other than renewals or extensions) any of its real property leases, place any of the Collateral with any third party (other than the sale of merchandise in the ordinary course of business and as otherwise set forth in the agreement), incur additional indebtedness, create any liens or encumbrances on any of its collateral, make certain investments, make any loans or advances and engage in certain transactions with affiliates. The Loan and Security Agreement also contains a covenant that prohibits us from paying cash dividends to our stockholders. In addition, the Loan and Security Agreement requires the Company to maintain availability under the credit facility of at least 12.5% of the then extant revolving credit loan ceiling.
The Loan and Security Agreement contains certain events of default, including but not limited to the Company’s failure to make payments under the Loan and Security Agreement, the Company’s failure to extend or renew the lease agreement for the Company’s distribution center in Lockbourne, Ohio, a material breach of the representations and warranties, or a failure to comply with the covenants contained in the Loan and Security Agreement, the acceleration of any other indebtedness of the Company, the occurrence of an event of default under any agreement between the Company and the lender, an uninsured loss to a material portion of the Collateral, the imposition of, or entry of judgment against the Company in, certain legal proceedings, bankruptcy or receivership and the occurrence of a liquidation or change in control of the Company. Upon the occurrence and during the continuance of an event of default, the lender may declare all of the Company’s obligations under the Loan and Security Agreement immediately due and payable (provided, however, that if the event of default is triggered by the institution of bankruptcy proceedings against the Company, all of the Company’s obligations under the Loan and Security Agreement shall immediately become due and payable).
The foregoing description of the Loan and Security Agreement is qualified in its entirety by reference to the provisions of the Loan and Security Agreement attached as Exhibit 10.59 to this annual report on Form 10-K.
PART III
Item 10.
Item 10.
Directors and Executive Officers of the Registrant
Information regarding our Executive Officers required hereunder is set forth in Item 1 of Part 1 “Business - Executive Officers of the Registrant.” The information required hereunder regarding our Directors is incorporated by reference from our Proxy Statement to be filed in connection with our 2006 Annual Meeting of Stockholders. The information required hereunder regarding Compliance with Section 16(a) of the Securities Exchange Act and our Code of Ethics is incorporated by reference from our Proxy Statement to be filed in connection with our 2006 Annual Meeting of Stockholders.
Item 11.
Item 11.
Executive Compensation
The information required hereunder is incorporated by reference from our Proxy Statement to be filed in connection with our 2006 Annual Meeting of Stockholders.
Item 12.
Item 12.
Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters
The information required hereunder is incorporated by reference from our Proxy Statement to be filed in connection with our 2006 Annual Meeting of Stockholders.
Item 13.
Item 13.
Certain Relationships and Related Transactions
The information required hereunder is incorporated by reference from our Proxy Statement to be filed in connection with our 2006 Annual Meeting of Stockholders.
Item 14.
Item 14.
Principal Accountant Fees and Services
The information required hereunder is incorporated by reference from our Proxy Statement to be filed in connection with our 2006 Annual Meeting of Stockholders.
PART IV
Item 15.
Item 15.
Exhibits and Financial Statement Schedules
Documents filed as a part of the report:
1. Financial Statements
The following consolidated financial statements of the Company are included in Item 8:
Report of Independent Registered Public Accounting Firm
Balance Sheets
Statements of Operations
Statements of Stockholders’ Equity (Deficit)
Statements of Cash Flows
Notes to Financial Statements
2. Financial Statement Schedules
All schedules have been omitted because they are inapplicable, not required or the information is included in the Consolidated Financial Statements or Notes thereto.
3. Exhibits
(1)
Incorporated by reference to identically numbered exhibits to the Company’s Registration Statement on Form S-1, which became effective on September 24, 2003.
(2)
Incorporated by reference to identically numbered exhibits to the Company’s Annual Report on Form 10-K for the period ended March 28, 2004.
(3)
Incorporated by reference to identically numbered exhibits to the Company’s Annual Report of Form 10-K for the period ending April 3, 2005.
*
Confidential treatment granted with respect to certain portions of this Exhibit.
**
Material has been omitted pursuant to a request for confidential treatment. Omitted portions have been filed separately with the Securities and Exchange Commission.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized as of June 29, 2006.
REDENVELOPE, INC.
By:
/s/ Polly Boe
Polly Boe
Chief Financial Officer
Date: June 29, 2006
KNOW ALL MEN BY THESE PRESENTS, that each person whose signature appears below constitutes and appoints Kenneth Constable and Polly Boe, and each of them, his or her attorney-in-fact with power of substitution for him or her in any and all capacities, to sign any amendments, supplements or other documents relating to this Annual Report on Form 10-K they deem necessary or appropriate, and to file the same, with exhibits thereto, and other documents in connection therewith, with the Securities and Exchange Commission, hereby ratifying and confirming all that such attorney-in-fact or his substitute may do or cause to be done by virtue hereof.
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.
EXHIBIT INDEX
(1)
Incorporated by reference to identically numbered exhibits to the Company’s Registration Statement on Form S-1, which became effective on September 24, 2003.
(2)
Incorporated by reference to identically numbered exhibits to the Company’s Annual Report on Form 10-K for the period ended March 28, 2004.
(3)
Incorporated by reference to identically numbered exhibits to the Company’s Annual Report of Form 10-K for the period ending April 3, 2005.
*
Confidential treatment granted with respect to certain portions of this Exhibit.
**
Material has been omitted pursuant to a request for confidential treatment. Omitted portions have been filed separately with the Securities and Exchange Commission.