Looking Further Into RedEnvelope

In my previous article, I argued that investors looking into Hidden Gems recommendation RedEnvelope (NASDAQ:REDE) should think of the company less like a traditional online/mail-order retailer and more like a Book-of-the-Month club. With this kind of a business, growth in sales, earnings, and even free cash flow cannot tell you the whole story. The measurements I introduce below fill in the gaps.

Revenues per order
Why you need it: There are two primary reasons why revenues would increase for this company: either more shoppers are placing orders with RedEnvelope or the company has successfully introduced higher-priced products. The former is arguably more sustainable than the latter. Gift spending is controlled by disposable income, and there is an upper limit to how much money the company can realistically expect to get from its customers in a single visit. I wouldn't expect revenues per order to increase at anything above low-single-digit rates without major expansions into more expensive product categories. As these expansions tend to be rare, they are not a reliably constant growth driver.

How to get it: The company reports this number -- total revenues divided by orders shipped -- so you won't have to do any calculations to find it. I've summarized the data from the past few years in the table below:

What to look for: You don't want to see any non-seasonal decline in revenues per order, because that means customers prefer the discounted/cheaper products or, worse, are buying fewer items during each visit. Thankfully, with the exception of the Q3 2004 blip, these numbers are rising. But note that in the last four quarters, revenues per order rose an average of 8% over the year-ago quarters. This rise coincides with the company's expansion into jewelry, which is something keep in mind when projecting future growth.

Growth in customer file
Why you need it: RedEnvelope keeps an extensive customer file and updates investors on its size every quarter. Increases in the file tell us how many new customers ordered from RedEnvelope and allow us to feel the pulse of the company's growth. Since RedEnvelope's major expected source of future growth is connecting with brand-new customers, absolute number growth in the customer file is an ideal way to see how well the company is meeting that goal. I suggest a focus on the absolute numbers because slowing growth in percentage terms is not necessarily a bad thing in this case -- as long as the company is getting new customers, its model is working.

How to get it: RedEnvelope updates this number, rounded to the nearest 100,000, every quarter. I've dug through the company's past 10-Qs and proxy filings to track the progression of the customer catalog as far back as Q4 of fiscal 2002:

What to look for: Currently, RedEnvelope is consistently adding about half a million customers to its file each year, which shows that the concept still has a lot of room to run. Also note that customer catalog growth may indicate more good news than trouble. While a sharp spike in growth usually indicates that the company is growing in popularity, a decline can be caused by anything from a temporary marketing snafu to a more serious issue of market saturation. Additionally, customer file growth should be compared to marketing spending -- if the company has ramped up its advertising while its growth rate remains unchanged, that means new customers are becoming more expensive to reach. This, in turn, will likely lead to margin erosion.

Percentage of existing customers reordering
Why you need it: While it's clearly important to get new customers and increase sales, what ultimately matters for RedEnvelope is how many customers in its file can be convinced to return to the site in any given quarter for a repeat gift purchase. The company will never generate significant profits if customers visit its website once or twice and then never return. Revenue growth won't tell you anything about who is doing the buying or if customers are indeed returning regularly.

How to get it: This number requires sizable calculation and estimation. Also, this is not an exact measure, but the margin of error is small enough not to matter in the end. First, for each quarter we'll need to find:

• How many orders the company shipped
• What percentage of revenues were attributable to existing customers
• The average revenues per order for existing and new customers
• How many new customers were added to the customer file

That last item is a problem -- except for the last two quarters, RedEnvelope has always rounded its reported number of new customers to the nearest 100,000. We need more precise numbers.

We can get them by asking the following question: Can we assume that new customers' revenues per order aren't drastically different than those of existing customers? Let's look at data provided by RedEnvelope in Q3 2005. We'll use the percentage of revenue attributable to new customers (55.3%), multiply it by total revenues for the quarter ($47.5 million), and then divide the total by the number of new customers added in the quarter (285,000). The result -- $92.16 -- is the average revenues per order for new customers.

Perform the same calculation for existing customers and we get $80.43 in revenues per order. While the new customers' number is 14% larger, the difference is small enough that we can proceed with our earlier assumption. Thus, for all the previous quarters where we only have customer catalog totals rounded to the nearest 100,000, we can assume that new customers spend roughly as much as existing ones, then determine how many new customers were really added. (You can adjust the numbers to reflect the fact that revenues per order for new customers might be, on average, 14% higher, but it doesn't make a significant difference in the final numbers. I go forward with the assumption that on average, new customers spend 14% more).

Now that we have the number of orders placed by those already in the customer file, we can divide it into the customer file size reported at the end of the previous quarter to figure out how many repeat orders the customer file generated. Using Q3 2005 numbers, we would divide the number of orders from existing customers, 264,000 (44.7% times 285,000), into 2,000,000, the number of customers in the file reported at the end of Q2 2005. The final result, 13.2%, gives us the customer catalog's rate of return.

Here are the aggregate numbers for all such calculations in table format. For some quarters, I was able to find out from SEC filings exactly how many new customers RedEnvelope added to the file -- for all the other quarters I had to estimate the number (hence the italics) as outlined above.

Estimated number of orders placed by those already in the customer catalog (and the corresponding rate of return):

What to look for: First, focus on percentages. If they show a clear pattern of falling, there is a problem. A falling return rate from the customer file means that RedEnvelope's churn is increasing as more and more customers choose not to purchase any of the company's offerings. Second, make sure you compare the percentages to the same quarter from last year, because the rates of return are seasonal. The third quarter sports the highest return rate because it includes the busy Christmas shopping period, while the second quarter stretches through the slow summer months of July to September, which contain few gift-giving occasions.

Finally, pay attention to the averaged rate of return for all four quarters over a given year, and compare them on a year-to-year basis. In fiscal 2003, RedEnvelope averaged a 12.5% rate of return on its customer file. In fiscal 2004, that rate dropped to 9.6% and in fiscal 2005 it's 9.2%.

The final verdict
Does this falling rate mean that RedEnvelope is broken? Not exactly. Getting an average 8%-9% quarterly return on its customer file is not bad -- it implies that for every half-million customers the company adds to its file, it can project to receive 45,000 orders from them each quarter, adjusted for seasonality. While that may not seem like much, as the company grows and expands its customer file, relying on these repeat orders will become an important source of revenue. But don't get me wrong -- I would still like to see this number inch back toward the double-digit range.

Realize that while these tools are powerful, they're only one part of the overall analysis. These measurements only focus on the revenue side of the equation, which does not always trickle down to the bottom line, as RedEnvelope itself showed last quarter. But as far as red flags go, examining these measurements gives you a level of clarity that just isn't possible from merely looking at sales and earnings growth.

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Fool contributor Marko Djuranovic owns shares of RedEnvelope and no other company mentioned in this article. The Fool has a disclosure policy.