RedEnvelope, Red Shareholders

Last week, RedEnvelope (Nasdaq: REDE  ) issued a press release disclosing that its annual report would be late because of a possible overstatement in the inventory-related component of its accounts payable liability.

New CFO Polly Boe uncovered the discrepancy during her review of the company's accounts. Once the errors are corrected, RedEnvelope's gross margins should increase, while its cost of goods sold should decrease. The overstatement, however, raises larger questions.

Though the filing problem seems an isolated incident, it comes as the most recent in a string of bungled figures released by the company. Given its fairly simple sales model, why does it seem like RedEnvelope's management is struggling to keep its house in order? Press releases are starting to sound less like business reports and more like bad excuses. The litany of overestimated earnings, underestimated liabilities, and poor forecasts must force investors to ask themselves, "What exactly is going on at RedEnvelope?"

Since going public, RedEnvelope has been forced to apologize for all kinds of management mistakes. The company has twice made earnings predictions that were later seriously revised. In the third quarter of fiscal year 2004, RedEnvelope slashed its expectation of a total net income of $4.3 million to $4.7 million down to an estimated net income of $0.9 million to $1.2 million. Its expected revenues were $39.5 million to $42.5 million; they were lowered to $35 million to $35.7 million. RedEnvelope's explanation for the changes? Distribution snags and an unexpected rush of holiday demand for products the company had purchased conservatively.

The forecast for the fourth quarter of fiscal year 2005 was adjusted from between $0 and $500,000 to a net loss of $3 to $3.5 million. RedEnvelope eventually posted a $3.8 million loss for the quarter. Gross margins were nine points lower than expected -- a result of conservative return reserve estimates, poor Valentine's Day sales, and higher than expected inventory adjustments. For any company, having to lower publicly released figures is not something easily swallowed. With three report revisions in a little more than a year, RedEnvelope management seems to be having serious trouble running the company.

Shortly after each of these mishaps, an upper-level employee has "left" the company -- ostensibly because they were responsible for the problem. Pamela Knox, senior vice president of marketing, went to explore other opportunities after the holiday season debacle in 2004. CFO Eric Wong resigned after the disappointing fourth-quarter numbers in March 2005. Following lower than expected fourth-quarter numbers and the filing delay, the company announced that Chairman Michael Moritz, who survived last summer's nasty proxy fight, will not seek re-election at this year's annual meeting.

While it's possible that these problems are singular events that have been properly dealt with, the close occurrence and magnitude of these mistakes seems to point to a larger problem with the company's management. The imminent departure of the chairman, combined with the promise of founder Scott Galloway to launch another proxy fight if the board doesn't accept his nominees or effect other governance changes, point to shareholders moving toward more serious management changes. However, people have been "leaving" RedEnvelope -- and the company's problems haven't been leaving with them. Investors must be wondering whether enough small changes have been made, and whether it's high time the entire management team try "exploring other employment options."

RedEnvelope was recommended 18 months ago by Fool co-founder Tom Gardner in our Motley Fool Hidden Gems small-cap newsletter. Since then, we've been treated to a declining stock price and the soap-opera-like atmosphere of repeated bombshells and accompanying management shuffles. In each case, Tom's assessment has been the same: The core business is strong and very promising. But as the hits keep on coming, it becomes increasingly difficult to give RedEnvelope's management a pass. Without a doubt, this is the Hidden Gems selection with the shortest leash.

Unless management shows that it has better control of all elements of the business, I fear that this company is doomed to remain "perpetually undervalued." The recent restatement, while ostensibly "good" news, does nothing to dispel our ongoing concern in this regard.

Join Motley Fool Hidden Gemstoday -- for free. Tom Gardner is offering a no-risk 30-day trial to the service. Or, for a limited time, sign up for one year and we'll give you our just-released Blue-Chip Report 2005: 10 Monster Stocks for the Next Decade. Click here for more information.

Fool contributor Andrew Patterson does not own any stocks mentioned in this article. The Motley Fool has a disclosure policy.


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