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RedEnvelope, Inc. (REDE)

Q4 2006 Earnings Conference Call

May 16th, 2006, 4.30 PM

Executives:

Andrew Greenebaume, Investor Relations

Ken Constable, President and Chief Executive Officer

Polly Boe, Chief Financial Officer

Analysts:

Kristine Koerber, JMP Securities

Grange Johnson, LaGrange Capital

Craig Bibb, Jasper Funds

Presentation

Operator

Thanks for standing by, everyone. Welcome to the RedEnvelope Incorporated Q4 earnings conference call. Operator instructions. At this time, I would like to turn things over to Andrew Greenebaume for opening remarks and introductions. Please go ahead, sir.

Andrew Greenebaume, Investor Relations

Thank you. Good afternoon ladies and gentlemen, and welcome to RedEnvelope’s Q4 and FY2006 conference call.

With us this afternoon are Ken Constable, President and Chief Executive Officer; and Polly Boe, the Chief Financial Officer. By now, everyone should have access to the earnings release, which went out earlier today. If you have not received your release, it is available on the investor relations portion of RedEnvelope’s website at www.redenvelope.com, and by clicking on the ‘about RedEnvelope’ tab. This call is being webcast and the replay will be available on the company’s website for three months after.

Before we begin, we’d like to remind everyone that the prepared remarks contain forward-looking information regarding future events and the future performance of the company. We may make additional forward-looking statements in response to your questions. These statements do not guarantee future performance, therefore undue reliance should not be placed upon them. We refer all of you to RedEnvelope’s most recent 10-Q and 10-K filings with the Securities and Exchange Commission as well as the Safe Harbor statement today’s earnings release for more detailed discussions of the factors that could cause actual results to differ materially from those projected in any forward-looking statements. RedEnvelope assumes no obligation to revise any forward-looking projections that may be made in today’s release or call. With that, I’d like to turn the call over to Ken Constable.

Ken Constable, President and Chief Executive Officer

Thank you, Andrew. Good afternoon and thanks for joining us today as we discuss our results for Q4 and fiscal year ended April 2nd 2006. Today I’ll briefly review those results and then spend some time talking about our strategy to achieve profitability, then grow our revenue profitably. Polly will then give you additional detail on our operating and financial results, as well as walk you through our fiscal 2007 guidance. I will conclude the prepared portion of the call with a few closing remarks before we take your questions.

In FY06 we delivered $115.2 million in revenue, in line with the revised guidance we gave in January. However, our earnings were a disappointment. In short, we focused on growing our top line via promotion, advertising and catalog circulation as a means to achieve profitability. But when we fell short of our revenue expectations, the net effect was a greater than anticipated earnings loss. In addition, in Q4 we faced pressures from costs related to changes in leadership. For the year, we recorded a net loss of $5.6 million, or $0.62 per diluted share. Polly will discuss this in more detail in her comments about Q4 and FY06.

As the new President and CEO of RedEnvelope, I believe that we have an exciting opportunity to achieve profitability, generate profitable growth and long term, become the leading upscale gift brand in the world. Our goal for FY07 is to demonstrate our financial viability and build a stable foundation that will enable us to achieve profitability before equity compensation expensing. In FY08 and beyond, we intend to build on this foundation with accelerated profitable growth. We plan to achieve this two-stage approach by focusing our strategic attention on the relationship-building essence of gift giving by simplifying our business and by executing with excellence. We believe in the fundamentals of our business model. RedEnvelope has a strong brand identity as evidenced by an iconic signature red box. Our products are distinctive and relationship-oriented and many are proprietary.

We employ a direct multi-channel retail strategy through our web store and phone store. We maintain a customer database of 2.9 million names, up 574,000 from last year. Our fulfillment is accurate, on time and personalized if our customers wish. Our recipients benefit from a memorable out of box experience and a generous satisfaction policy. We deliver superior customer service 24x7. Relationship building is the essence of gift giving and will be our strategic focus going forward. We understand that gifts are a means to an end, and will act as a catalyst for the celebration and nurturing of personal relationships. As such, we dedicate our business to better understanding our customers’ relationships and recipients and to providing gifts and gift services that help them build strong relationships. Historically, RedEnvelope has tried to be all things to all people, by offering an extensive product assortment, ostensibly suitable for any and all recipients, occasions and price points.

This broad but shallow strategy has diluted our customer value proposition and driven complexity and cost into our business. Therefore the second move in our two-step approach to profitable accelerations is to simplify our business. We plan to achieve this by concentrating our target focus as follows: our target customers will be women in their relationship nurturing years, which range from 23 to 65 years of age. Our core audience is 30-50 years old. This does not exclude our valued male customers, but simply ensures that we focus strongly on our core female customer base.

Our target recipients will be women’s closest personal relationships. That is to say, their inner circle of friends and family. Our target occasions will be the most meaningful and recurring dates in women’s closest personal relationships, such as birthdays, anniversaries, new babies, holidays, valentines day, mother’s day and father’s day. Our target categories will be the gift categories that women prefer for celebrating these target occasions with their inner circle relationships. This includes several of our core product categories, such as Jewelry, Home, Men’s Accessories and Baby. We believe this tight focus will enable us to employ a deeper pressure product strategy.

In addition to concentrating our strategic focus on simplifying the business, we intend to execute with excellence. As such, we are creating a culture of increased accountability within the company and implementing a more disciplined approach to financial and operations management. This will be underwritten by a ‘profit first’ planning philosophy in FY07 based on realistic revenue growth, enhanced margins, more productive marketing spending, price operating cost controls and disciplined inventory management. Once we’ve established a strong and profitable foundation for the business in FY07, we believe that we will be well positioned to generate profitable accelerated growth. We plan to achieve this by a disruptive(?) approach to the gift market, by driving customer retention, by developing efficient new customer acquisition channels and by further leveraging our brand.

Our strategy is to provide the most customer-centric gift experience. Our core business is gift giving, not self-consumption, and we see a significant opportunity to reshape the gift market by delivering a highly desired value proposition to RedEnvelope’s customers. We plan to deliver the highest probability of relationship nurturing success and the most fulfilling gifting experience with minimal time and stress investment. The core element of this model will be to leverage our customer and recipient database to better understand relationships, key gift occasions and the types of gifts that are most appropriate for these occasions. We believe that this will enable us to effectively target our gift recommendations and reminders.

We believe that our customer centric gift giving strategy will drive increased customer retention through increased relevance. Additionally, we will increasingly evaluate and test new offline and online channels for efficient new customer acquisitions. We also believe that our superior recipient experience will facilitate productive recipient marketing. Finally, our signature red gift box is an emerging icon in the gift industry. We intend to significantly increase household penetration in order to drive increased awareness and affinity for our brands. Net-net, we plan to prove the financial viability of our business model in FY07 by targeting achievable growth, enhancing margins, driving increased marketing spending productivity and tightly controlling operating expenses and inventory management. We believe this will deliver positive profitability before equity compensation expensing.

In FY08 and beyond, we plan to drive profitable accelerated growth opposite solid, financial and operational foundations established this year. We are committed to maximizing shareholder value. In addition to certifying our financial and operational foundation in FY07, and implementing our strategy to drive profitable acceleration in FY08 and beyond, this also includes exploring strategic alternatives. We recently engaged W.R. Hambrecht as the financial advisor to assist in this effort. This includes but is not limited to the possible sale to or merger of the business with another entity. There can be no assurance that this exploration and strategic opportunity will result in a transaction. We will update you in the event we have something definitive to report.

With that, I’d like to turn the call over to Polly to discuss our financial and operational results in more detail. Polly?

Polly Boe, Chief Financial Officer

Thank you, Ken, and welcome everyone to our Q4 and FY06 earnings results conference call. Our revenue for the quarter and year were in line with our revised guidance and we were pleased with our top line performance. But as Ken discussed, our earnings were a disappointment. Net revenue for Q4 FY06 was $22 million, essentially flat with the $22.2 million for Q4 FY05. As a reminder, FY06 contained 52 weeks versus 53 weeks in FY05, with the extra week falling in Q4 last year. In addition, FY05 included approximately $1.5 million in revenue related to the delivery of Q3 orders that were delayed due to extreme weather conditions. This revenue was recognized in Q4. Given the calendar shift and the Q3 orders that were recorded in Q4 FY05, the year on year revenue comparison is not meaningful. In Q4, we posted a 4% decrease in order ships but a 4% increase in average revenue per order as we cut back on promotional activity and free shipping. Gross margin for Q4 FY06 was 48.8% compared to 47.4% during the same period last year.

For FY06, revenues increased 11.6% to $113.2 million compared to $101.4 million in FY05. Shipped orders grew 10.1% but average revenue per order increased a modest 1.4%, primarily due to the discounted shipping offered during the holiday season as well as a shift in product mix. Our online channel continues to grow faster than the catalog and is proving to be a more efficient way to drive business. Jewelry and Home remain our strong gift categories and as Ken mentioned, we are planning to optimize our product assortment and focus on selected core categories. In FY06, we shipped 1,434,000 orders and our revenue per order was $79, up slightly from $78 in FY05. Our gross profit per order was flat year on year, at $40 and the customer help file grew 2.9 million names at the end of FY06, up 574,000 names since last year and up 101,000 names since Q3.

Gross margin for the full fiscal year was 51.2% compared to 52% last year. This is primarily due to shipping related promotional activities in our fiscal Q3. We’ve already significantly reduced our shipping promotions and plan to seek further margin improvements throughout FY07 as more of our products are developed by our in-house design team and sourced overseas. Our fulfillment expenses as a percent of revenue remains flat at approximately 16% for Q4 FY06 versus the same quarter a year ago. In FY06, fulfillment expenses accounted for 14.2% of net revenues, down from 15.4% in FY05. This decrease in annual fulfillment expenses as a percent of revenues was primarily due to our improved efficiencies in warehouse management as well as our ability to leverage fixed costs across the higher net revenue. Marketing expenses for Q4 2006 decreased 8.4% to $4.6 million or 20.9% of net revenues, compared to $5 million or 22.6% of net revenues for Q4 2005. For the year, marketing expenses decreased to 23.2% of net revenue and 24.1% of net revenue in FY05.

We continue to explore strategies to improve the catalog’s efficiencies as a marketing tool, including changes to circulation, product assortment and creative presentation. Our G&A expenses increased to $7.3 million in Q4 FY06, compared to $5.1 million in Q4 FY05. In FY06, G&A expenses increased to $21.5 million compared to $17.9 million in FY05. This YoverY increase was primarily due to approximately $1.5 million in one-time leadership transition costs during Q4 FY06. Our top line growth was offset by high expenses and we were not able to achieve profitability for the fiscal year. For Q4 FY06 we reported a net loss of $4.5 million or $0.49 loss per diluted share, compared to a net loss of $3.1 million or $0.35 loss per diluted share in Q4 of FY05. Net loss for FY06 totaled $5.6 million or $0.62 loss per diluted share compared to a net loss of $5.2 million or $0.59 loss per diluted share in the prior year.

Now turning to the balance sheet, as of April 2, 2006, our cash and short-term investments were $10 million compared to $19.2 million last year. This YoverY decline is due to the net loss and the increase in inventory. We ended FY06 with inventory of $19.7 million, up from $14 million at the end of FY05. Primarily, as a result of recent purchases of core products. We continue to have no debt, but we do expect to encounter seasonal borrowing needs in order to build holiday inventory and we are in the process of seeking a line of credit. In FY06, we spent approximately $3.1 million on capital expenditure and our target for FY07 for capital expenditure is expected to be approximately $3.5 million.

Turning to guidance, I need to point out that incorporated into our forecasts are trends we have seen to date, and I need to remind you that actual results could vary from our guidance. We currently expect net revenues for FY07 to grow between 7-10% on FY06 and we expect to achieve profitability prior to equity compensation expensing as required by FAS123R. This performance will be achieved through a combination of efforts, including modest top line growth, no plans for shipping discounts without an order value threshold, elimination of inefficient catalog circulation and thematic advertising, tight cost controls and cautious inventory management as well as the absence of one-time extraordinary expenses.

Now, I’ll turn the call back to Ken for some closing remarks before we open the call to your questions.

Ken Constable

Thanks, Polly. To summarize, we are impatient for profit and patient for growth. Our two-step approach is to first demonstrate our financial viability and build a stable foundation for long-term profitable growth in FY07 and then to drive accelerated profitable growth in FY08 and beyond. Our brand is strong and our business model is sound. We have an experienced and confident management team, a capable and motivated work force and a supportive board of directors. Our long-term outlook is positive and we are committed to revitalizing our business by concentrating our strategic focus, simplifying our business and executing with excellence. I believe in our ability to achieve profitability pre equity compensation expensing in FY07 and profitable accelerated growth in FY08 and beyond. With that, I’ll turn the call back to the operator so that we can take your questions.

Questions and Answers

Operator

Thank you, Mr. Constable. Operator instructions. First up in the roster is Kristine Koerber, at JMP Securities. Please go ahead.

Q - Kristine Koerber, JMP Securities

A couple of questions. First of all, you talked about focusing in on particular categories and your core female customer. Are we going to see an elimination of categories? I guess my real question is around inventory. It’s at 40%. Are we going to see some markdowns to get rid of some of the excess inventory?

A – Ken Constable

In terms of the focus on core categories, we imagine as we tighten our focus on customers and recipients and on occasions that we will probably be getting into a more narrow assortment in terms of category. We don’t anticipate that we would be doing anything precipitous and so we would probably have a shift in mix as opposed to anything that would be dramatic.

Q - Kristine Koerber, JMP Securities

Then as far as inventory at 40%, can you talk about the quality of the inventory?

A – Ken Constable

We think that principally that inventory is concentrated in core items. Those are the things that we would continue to feature season after season. Certainly the inventory would be normalizing as we go through the next holiday season.

Q - Kristine Koerber, JMP Securities

As far as the merchandise margins, I know that’s one of the strategies to help drive profitability going forward. Where do you see merchandise margins going over the next year or two? In what percentage of your mix currently is being sourced overseas?

A – Ken Constable

We’re pretty pleased with our merchandise margin right now. We think, in terms of some of the margin enhancement that I talked about, that you’ll see a lot of that source from shipping margin in the sense that we offered some fairly significant shipping discounts last holiday season which we don’t intend to incur this year. That’s where you see the majority of the appreciations. What was the second part of the question?

Q - Kristine Koerber, JMP Securities

I guess, longer term I was just wondering where the margins are going to be, the overall gross margin.

A – Ken Constable

I think, you know, we are pretty pleased with where they are right now. We might see some marginal appreciations as we get past the dip that we took in FY06 as a result of that shipping discount. After we get out of that, I think you’ll see us reasonably constant.

Q - Kristine Koerber, JMP Securities

Where do you stand as far as hiring a new G&M(?)?

A – Ken Constable

We have an active search underway, we’ve seen several promising candidates and we hope to close the deal before too long.

Q - Kristine Koerber, JMP Securities

Then lastly, what are you anticipating as far as impact on 2007 for stock-based compensation?

A - Polly Boe

Kristine, it’s pretty complicated, as you can appreciate. We’re trying to get our hands around a number. We’re not yet ready to provide an estimate, but we will shortly, I guess, once we’ve got a better sense of it.

Operator

Operator instructions. We have a question from Tim Gordon at LaGrange. Please go ahead.

Q – Grange Johnson, LaGrange Capital

It’s actually Grange Johnson. Just a question on how the search for a merchant(?) is going, where you are in that process?

A – Ken Constable

Well, we have the search out with a recruiter arranged and we’ve seen a number of promising candidates. I think we’re getting relatively close and we hope to have something to announce before too long, but we’re not quite there. We want to make sure that we have world class standards here in terms of the person that we source, so we are going to be very deliberate in this process, at the same time recognizing its importance going forward. We’re very pleased with our product development and merchandising team and they’ve done a great job of preparing us for holiday for this coming year. I’m very confident that we’re in great shape.

Q – Grange Johnson, LaGrange Capital

Is there a demarcation line where it doesn’t make sense to get a merchant on board, because you’re locked in for the holiday season? Or is it something that, even if they come in and say in the summer time they can start planning for next year, they can perhaps tweak the holiday assortment?

A – Ken Constable

We’re just beginning the planning for next year as we speak, so we certainly need to have that kind of leadership here. We still have a great sense of urgency here.

Operator

Next up is Craig Bibb at Jasper Funds.

Q – Craig Bibb, Jasper Funds

The decision to hire an advisor. Was that driven by – were you approached, or just a need for capital?

A – Ken Constable

I don’t think that we can really discuss what the underlying issues were there, Craig, to tell you the truth.

Q – Craig Bibb, Jasper Funds

Why not?

A – Ken Constable

What I can generally say is it’s our responsibility to investigate all strategic alternatives and you heard from my earlier discussion, from the standpoint of our internal strategic plan, we have a pretty firm view of the future. I think it’s responsible for us to make sure we consider all of our options, so that’s what we’re endeavoring to do with this kind of parallel process.

Q – Craig Bibb, Jasper Funds

If you were pushed, you would have to announce that. Is that correct?

A – Ken Constable

I don’t think so.

Q – Craig Bibb, Jasper Funds

OK. Thank you.

Operator

We have a follow-up question now from Kristine Koerber.

Q - Kristine Koerber, JMP Securities

An additional question I missed. The costs in Q4 – why were fulfillment and expenses flat YoverY?

A – Polly Boe

I think it was in line with the volumes that were set as well, so it wasn’t anything unusual that’s happened in Q4 in our fulfillment expenses.

Q - Kristine Koerber, JMP Securities

But you had that $1.5 million additional last year? I just thought we’d see a little more leverage in that line in the quarter.

A – Polly Boe

I don’t think it was probably material enough. Off the top of my head, I can’t think of anything that was materially different.

Q - Kristine Koerber, JMP Securities

OK. Thank you.

Operator

Operator instructions. At this time there appear to be no further questions. I’d like to turn things back over to Ken Constable for some brief closing remarks.

Ken Constable

Thank you, everyone, for joining us today. We appreciate your time and attention. We all look forward to meeting with you again in 90 days to discuss the results of our first quarter. Thank you.

Operator

Thank you again, everyone, for joining us today. That will conclude the conference call. Have a good day.

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