I first stumbled upon RedEnvelope
What a ride it's been. In the two short years since its IPO, the company has presented investors with wild valuation gyrations, holiday shipping snafus, a heated proxy battle and, finally, impressive numbers in the latest financial quarter.
I've written about RedEnvelope before, and how important it is for the company to establish its brand in order to succeed as an online retailer. But in this column, and one to follow, I would like to further analyze how investors should view the company and its future profit-generating prospects.
Similar, but not alike
Among its competitors, RedEnvelope lists the likes of online behemoth Amazon.com
While these retailers are the company's main competition, RedEnvelope isn't your standard retailer. Its obvious lack of any brick-and-mortar stores aside, RedEnvelope stands somewhere between Tiffany's and Amazon.com. Its offerings are broader and more affordable than Tiffany's, but more focused and pricier than what you'd find on Amazon.com.
One key difference: RedEnvelope emphasizes in-house designs that carry a higher profit margin. While clearly profitable -- Sharper Image relies on a similar business plan -- this approach also adds some inherent uncertainty to the sales process. Unique and personalized designs make it difficult to increase supply quickly if demand rises. Thus, estimating demand becomes just as important as the product's design. Make too little, and you're losing out on potential sales; make too much, and you're stuck with unsold inventory that must be discounted or written off. Though every business with inventory faces this problem, RedEnvelope's is augmented by the seasonal nature of its gifts and the fact that uniquely designed gifts cannot be ordered en-masse from the supplier.
In addition I believe that RedEnvelope's focus on gift-giving occasions demands a different approach to evaluating its future profit-generating prospects. I think that RedEnvelope is most like the book-of-the-month club -- call it a gift-of-the-quarter club.
There are plenty of trinkets in RedEnvelope's inventory that you might like to buy for yourself. But most of the company's items are luxury goods that you certainly don't need every day, or even occasionally. For the most part, you go to the site to buy gifts for your friends, family and co-workers.
To that extent, the company's business model relies on getting you to buy something from them via enticing advertising, adding you to their customer file, and then -- and this part is key -- luring you back to the website at least once per quarter to make a $60-$80 purchase. Once you become a customer, you're bombarded with seasonal gift ideas for Mother's Day, Valentine's Day, Christmas, and so on. Sprinkled throughout the year are gift suggestions for non-seasonal events like birthdays, anniversaries, weddings, and baby showers. The company would like you to return once per quarter -- or per month -- but the grouping of holiday events makes that unlikely.
Calculating churn. for a retailer?
RedEnvelope's future success lies in expanding its customer file while retaining a high enough percentage of current customers as consistent quarterly buyers. This challenge is not unlike churn problems well-known to subscription-based businesses -- adding lots of new customers doesn't help much if you're losing existing customers just as quickly.
RedEnvelope's customers don't exactly leave; instead, they choose not to buy any gifts in a particular quarter, much like a book-of-the-month club member might decline that month's offering. If too many previous customers don't become repeat buyers -- for reasons ranging from unchanging inventory to too-high price points -- the company will likely never reach significant levels of profitability. What are these exact levels? I'll discuss that in a follow-up column, coming soon.
We'll need to run some tests
When monitoring a company's financial well-being, investors should keep an eye out for free cash flow, rising inventory levels, and marketing and SG&A spending that outpaces growth in sales. As RedEnvelope grows, marketing spending should rise more slowly than top-line revenues; an expanding brand presence and customer base should hopefully allow the company to earn greater revenues without a bigger marketing budget.
Similarly, investors should also mind ratios of debt to cash. It's a relevant metric for companies in their start-up stages; as revenue streams fluctuate, debt can take a larger bite on a percentage basis. Additionally, interest coverage is not appropriate when earnings before interest and taxes are negative.
Other things to watch for: insider behavior and the overall multiple the market places on the shares. I suggest investors focus on the sales multiple until the company becomes profitable enough to warrant analysis by P/E ratio.
For the most part, RedEnvelope scores well here: it carries practically no debt and just about $24 million in cash net of debt. Sales are growing faster than marketing and SG&A spending, and insiders hold upwards of 20% of the company. So far, so good.
But the story doesn't end here; shareholders should keep track of four additional metrics as well. I believe that changes in these variables are much better indicators of the company's profit potential than traditional measures of top-line sales growth and relative increases in net income. You'll need to crunch these numbers on your own; the company doesn't directly provide them. But don't despair -- most require little, if any, calculation beyond figuring out the growth rate on certain reported items.
In the second part of this article, I will outline where to find the necessary information, how to construct these four metrics, and how to incorporate your findings into your own estimates of the company's future potential rate of return.
Fool contributor Marko Djuranovic owns shares in RedEnvelope, but not any of the other companies mentioned in this article.