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Online gift retailer Red Envelope was crushed (or perhaps crumpled) in trading on Tuesday after warning of an earnings shortfall. The stock closed at $11.60 Monday before the announcement, opened at $8.20 Tuesday morning, and only recovered slightly to $8.73 by close Wednesday. Details from the pre-announcement, and analysis that suggests that there may be more bad news to come:


Q1 (REDE's fiscal Q4) pre-announcement details:

  • Revenue of $21.5-$22.0 million, versus prior guidance of $21-$23 million.
  • Net loss of $(3.5)-$(3.0) million, verus prior guidance of net income between break-even and $500,000.

Updated fiscal year 2005 guidance:

  • Revenue of $100.7-$101.2 million versus prior guidance of $100 - $102 million.
  • Net loss of $5.6-$5.1 million versus prior guidance of a net loss of $2-$1.5 million.

Analysis

Note that the Q1 revenue shortfall is tiny - only about half a million dollars on a $22 million revenue base. Yet the earnings shortfall is huge - a swing of $3-4 million. Red Envelope explained the earnings shortfall in its press release as follows:

RedEnvelope currently expects its fourth quarter gross margin to be approximately 10 percentage points lower than anticipated ...attributable to the following factors:

  • Approximately three percentage points of the shortfall are due to lower-than-anticipated Valentine's Day demand, which resulted in higher discounting to drive revenues during both the Valentine's Day period and subsequently.
  • Approximately one percentage point of the shortfall is due to higher-than-planned inventory adjustments related to aged inventory and discontinued products.
  • Approximately three percentage points of the shortfall are due to higher-than-anticipated return rates during the fourth quarter of fiscal 2005.
  • Approximately three percentage points of the shortfall are due to a budgeting error that resulted in an overestimation of the Company's gross margin for the fourth quarter.

Alison May, President and Chief Executive Officer, said, "Our Valentine's Day business was below our forecast, causing us to discount more heavily than we anticipated in order to drive demand. We had a successful third fiscal quarter, and we were expecting a level of repeat purchases that did not materialize... We also experienced higher-than-anticipated returns this quarter as a percentage of sales. Our returns rate had been declining for most of the fiscal year, and we had expected this trend to continue into the fourth fiscal quarter. We now believe that any further reduction in returns rates will be more gradual... As part of reviewing our fourth quarter performance, we discovered an error in budgeting for costs of goods sold, which resulted in an overestimation of our gross margin and consequently our forecasted net income for the quarter."

These explanations are bizarre. Look at the first cause: 3% points of gross margin shortfall due to slack demand. A shortfall in demand should lead to a revenue shortfall as well as a profit shortfall, yet we know that revenue was roughly in line with guidance. Did Red Envelope really have the ability to cut prices fast enough to stoke demand, and is there enough short-term price elasticity for REDE's products to lift demand as soon as REDE cut prices by only 3%? Seems unlikely.

Now look at the second cause: 1% point of gross margin shortfall due to inventory write-offs due to aged and discontinued products. That would make sense if there had been a significant revenue shortfall (equals lots of unsold inventory), but revenue was roughly in-line. So why the inventory write-down?

The third cause: 3% points of gross margin shortfall due to higher return rates. But return rates don't fluctuate wildly during a quarter unless there is some problem with faulty merchandise, so this makes little sense.

The fourth cause: 3% points of gross margin due to... a budgeting error. A budgeting error???

Factors to worry investors:

  1. The exlanations don't make sense;
  2. According to REDE management, there are four different causes that contributed to a 10 percentage point shortfall in gross margin. One is an accident, two is a co-incidence, but three, four?
  3. This pre-announcement suggests that REDE's management has no grip on, or visibility of the company's business...
  4. ... and therefore raises the possibility that heads will roll. Ben Silverman writes (his entire piece is worth reading):
...an institutional investor whom I spoke to last June, told me about a visit to RedEnvelope's office. The investor had only done a limited amount of work on the company, and held no position at the time, but his visit left an extremely negative impression.

"[May] could not articulate a strategic vision for the company. I don't know if she was having a bad day, but she couldn't outline any kind of strategy. Everything was very haphazard," said the institutional investor, who called the company's management team "unimpressive" and "unsophisticated."

...Considering how poorly Alison May has executed, I'm throwing a red flag at the CEO of RedEnvelope, because she needs to go.

REDE chart below.
Rede_1

Source: Red Envelope (REDE) stamped by warning, but more trouble to come?