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Blurry Future for Sharper Image?

Much of the company's growth is based on Ionic Breeze, which is about to see stiff competition.

Its stock has soared this year, sales are booming thanks to a hot, must-have product, and it recently raised its quarterly guidance. So what's not to like about

Sharper Image

(SHRP)

?

Well, you might say it has something to do with d¿j¿ vu.

Three years ago, sales of the Razor scooter went through the roof, sending Sharper Image's earnings and stock price up with it. Then those sales came crashing back to earth, weighed down by a raft of cheap competition. With them went the company's earnings and stock price.

Now the company's fortunes are linked to Ionic Breeze, its flagship line of air purifiers. With new competition on the horizon, the danger is that history is about to repeat itself.

"They are a one-hit wonder," said Rob Wilson, who covers the company for Tiburon Research Group. "As soon as those sales dry up, they're going to crash." (Tiburon Research Group doesn't do investment banking.)

Sharper Image's stock has been one of the best performers in retail this year. Since the beginning of the year, the company's shares have soared 61.3%, closing regular trading Thursday at $28.12.

For the 12 months ending April 30, Sharper Image's sales were up 30% to $549 million, while the company had more than tripled its earnings to $16.4 million.

Sharper Image has continued that strong performance into the second quarter. Its overall sales in June increased 28% and its same-store sales, which measure results from like outlets open more than one year, rose 18%. Based on those results, the company increased its earnings guidance for the second quarter from a penny per share to 2 to 3 cents a share.

Meanwhile, despite the jump in the company's stock, Sharper Image is still trading at just 20 times its projected fiscal 2003 earnings, only a slight premium to slower-growing retailers.

Given these factors, many sell-side analysts have a buy rating on Sharper Image's stock.

Gary Holdsworth of Wedbush Morgan Securities is typical of the prevailing opinion on the sell side. Holdsworth, noting its sales growth, has a buy rating and a $34 price target on Sharper Image shares.

"The company has great sales momentum right now," said Holdsworth. "They find unique products and merchandise and market them so that people love them."(Wedbush Morgan has no investment banking business with Sharper Image.)

But the company's recent success could be deceiving.

In 2000, Sharper Image's revenue jumped 38% over its previous fiscal year to $405.9 million. The company sold $70 million worth of Razors that year, meaning that about 62% of its revenue growth year over year came from scooter sales. Those sales all but dried up the following year. In 2001, the company sold just $4.7 million worth of Razor scooters and its share price dropped 30%.

The company's hot new product now is a line of air-purification products that use current to ionize surrounding air molecules and, theoretically at least, clean the air of dirt and pollen.

The devices have quickly become a cornerstone of Sharper Image's line. In the first quarter of last year, sales of the Ionic Breeze products comprised 28% of the company's sales. That was up from the same quarter a year earlier, when they accounted for 26% of Sharper Image's sales. For all of 2001, sales of Ionic Breeze products comprised 16% of Sharper Image's revenue compared with 7% in the previous year.

Sharper Image stopped breaking out its Ionic Breeze sales last year. This week, company officials wouldn't say what fraction of Sharper Image revenue floats on the Breeze, just that it represents a "substantial portion" of sales.

Tiburon's Wilson estimates that "substantial portion" is now at about 30% to 35%.

Enter the Challenger

And that's what puts the company in such a precarious position, Wilson argues. The company's Razor scooter sales fell off a cliff when competitors released cheaper alternatives. Similarly, a significant competitor is looming in the air-purification market, he said.

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Homedics, a company that sells desktop fountains and personal care products, plans to release a line of air-purification products sometime later this year or early next year. Homedics' air cleansing system will be based on technology by a company called

Kronos Advanced Technologies

(KNOS)

.

Kronos' technology is far superior to that of Sharper Image, said company CEO Dan Dwight, citing the U.S. Army and Navy and corporate-jet maker Gulfstream as users of its technology.

Regardless of whether Homedics' Kronos-based product is superior to Sharper Image's, the company will have a leg up on Sharper Image in terms of distribution. Consumers can only buy Sharper Image's Ionic Breeze air filter through its own catalog, Web site or 125 retail stores. In contrast, Homedics sells its products through most of the major chain retailers, including

Wal-Mart

,

Target

,

Macy's

and

Walgreens

.

And that could soon mean the end of Sharper Image's Ionic boom, said Wilson.

"Right now, Sharper Image has no competition," Wilson said. "Once

a competing air purifier hits

Bed Bath & Beyond

, these guys are screwed. They've done a great job of selling the Ionic Breeze. I don't think they've done great job of selling anything else."

Wilson warned competition could send Sharper Image's shares back to $12.

Even Sharper Image bulls acknowledge the risk. Homedics and other potential competitors might well expand the market for air filtration systems, said Holdsworth. But they could also steal share from Sharper Image, he said.

Meanwhile, Sharper Image has yet to demonstrate that it has another hit product waiting in the wings to replace Ionic Breeze, said Holdsworth.

"We view that as a risk, but we think the company has learned from its experience with the Razor scooter," he said.