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Excerpts from Gilford Securities analyst Casey Alexander's recent update to clients on Dreams Inc. (DRJ):

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1. If FansEdge Succeeds, So Will Dreams

The Dreams story is that of a multi-faceted retailer. The company has sports memorabilia stores, both owned and franchised, under the Field of Dreams name. It has a wholesale memorabilia manufacturing arm known as Mounted Memories that also retails through outlets such as QVC. It owns and operates the Chicago Sun-Times Sports Collectible Show. These are all important to the company, but at this stage in the development of the story, for Dreams to succeed and thrive, the FansEdge and FansEdge.com stories have to play out, and play out big.

FansEdge.com is the online retailer that offers licensed sports products (player jerseys, products that feature team logos) as well as memorabilia. FansEdge.com now serves as the backbone for other internet retailers that want to work in the sports apparel space, providing web site management, inventory control, shipping and handling, billing, etc. This syndication business allows for significantly higher inventory turns and means that Dreams capacity utilization of corporate assets should eventually lead to faster absorption of overhead and greater long term profitability.

Many retailers have developed a successful brick & mortar (B&M) retailing concept, and then transitioned that concept into a web-based sales effort. Dreams is the first retailer that we know of that has started with a successful website, and then tried to transition that into a successful B&M retailing concept supported by the web site.

In late August, Dreams announced that it had secured sites for six FansEdge retail stores in the Chicago area. These six stores are in addition to the flagship store which was opened in May. These sites were secured under very favorable terms due to the economic dislocation. As we see it, the success of these stores is critical to the future of the Company.

2. The New Retailing Paradigm

Many successful online e-tailing concepts have emerged over the last ten years. E-commerce continues to grow despite the economic dislocation. FansEdge.com is no different. At the end of 2006 FansEdge.com was named the 289th fastest growing retailer on the web. The company actually improved that position at the end of 2007, rising to become the 216th fastest growing retailer on the web. FansEdge.com could generate revenue in the area of $50 million this year versus $39 million in 2007 despite the economic dislocation.

The new paradigm works like this. Taking advantage of the FansEdge.com brand, Dreams will open a total of seven B&M FansEdge stores in 2008. As a way to connect the online customer to the B&M customer, FansEdge will locate interactive computer terminals (kiosks) inside the store that connect to the FansEdge.com online inventory, thus offering far greater customer choice than can be carried in physical inventory in the store. It will also establish the connection between the retail storefront and the e-commerce website, in the hopes of making a customer connection both ways.

3. Why the Success of FansEdge is Critical

We recognize that the other divisions of the company have value. But we see the overall development of Dreams like this: If the combination of the FansEdge.com site and the FansEdge retail store format works, then Dreams will continue to open FansEdge stores and the FansEdge concept will ultimately dwarf the rest of the company. The online component of revenues is already more than half the total company sales. We could see this contribution growing to over 75% of total company revenues in the next few years.

This is also a case where the recession could actually work in FansEdge's favor. Every recession has given rise to new retailing concepts that go on to become terrific growth stocks for several years beyond. If the integration of the B&M stores with the online store works and creates incremental traffic, then Dreams will have the ability to open multiple stores every year and expand the geographical footprint. Thus, FansEdge could become another Finish Line (FINL) or Foot Locker (FL)-type concept. There will be no need to search for capital. The model will be self sustaining.

Dreams originally planned to open one or maybe two FansEdge B&M stores this year. Opening six is an ‘all in’ move. But we think it’s the right one. The average purchase in a FansEdge store is modest, which means that FansEdge could still be a reasonable choice for Christmas shoppers. And if the company gets through this cycle with any success and we can get to the phase of rapid B&M store growth, then this could be a tremendous stock from here.

4. An Example of the Upside from Syndication

Last week, Dreams announced the signing of a formidable new syndication partner in AOL Sports. AOL Sports has over 10 million unique monthly visitors, and in partnership with Dreams has launched the Fanhouse Fan Shop to market licensed sports merchandise and memorabilia. This account has huge potential to drive top and bottom line growth for Dreams.

The benefits of this relationship are significant. The Dreams syndication model pays AOL a fee that would approximately equate to what its own customer acquisition costs would be if the company had to go out and obtain access to all of the new customers on its own. So there is no loss of margin on the acquisition of these new customers. But importantly, it provides operating leverage fro the rest of the FansEdge operations, with higher volume, better inventory turns, and greater absorption of corporate overhead, thus leading to improved overall operating profitability. This deal really defines the syndication model.

5. Valuation

The P/E is less than 10X 2009 estimated EPS. We are raising our estimate for 2009 EPS in light of the AOL deal. It’s a ridiculous valuation. But today what isn’t cheap. The market couldn’t care less. No P/E based valuation is low enough to satisfy the sellers. None is low enough to attract a buyer.

But what is amazing is that the shares now sell just about equal to the tangible book value. Yet we judge the book value to be significantly understated, as have been the earnings the last couple years. Why? Because Dreams has expended several million dollars in system upgrades and business growth initiatives, many of which could have been capitalized but instead were expensed. Thus we have not just a growth play, but an asset play.

We also judge that price targets are no longer relevant at these levels. After all, a couple good days or the cessation of tax-loss selling and the stock could double in a couple of days. That still wouldn’t do anything to reflect the true potential of this concept. Therefore, we will suspend our price target but reiterate our Buy Rating.

Risks to Achieving Our Price Target:

Despite the fact that we have no stated price target, investors should still be aware that Dreams does have investment risks including but not limited to:

  • Continued declines in retail sales.
  • Failure to grow the FansEdge concept.
  • The ability to remain technologically up to date with a significant on line business format.
  • Failure to control costs.

Disclosure: The analyst owns and manages a hedge fund in which Dr. Philip Frost (a 14.7% shareholder of DRJ) is an investor.

Source: Dreams, Inc: FansEdge Is the Driving Force