Red Envelope Isn't Delivering

The promise of a proxy battle should be viewed with caution.
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Signs abound that a proxy battle is brewing at



, delighting its heretofore moribund shareholders. Maybe they should go back to sleep.

The stock has added 12% on heavy volume this week in a delayed reaction to co-founder Scott Galloway's expression of dissatisfaction with the company's management in a May 12 filing. That was followed by the disclosure that RedEnvelope's president and chief executive, Alison May, bought 10,000 shares in the company last week.

Recent financial performance suggests a fight is justified. But change has come slowly to the online gift purveyor in the past, and some worry that the current contretemps is just another distraction that could prolong the pain.

The company didn't return calls seeking comment.

To be sure, RedEnvelope is a solid online brand, with a strong name recognition that makes it the second-most popular destination for online gift-buying after


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. While it is not yet profitable, aggressive investors view the company as a strong growth candidate, on the basis of its impressive sales gains and customer retention.

That status, coupled with the 50% decline in its stock since a late-2003 IPO, has attracted a flock of institutional investors and value hunters. Its largest investor, billionaire venture capitalist Michael Moritz with

Sequoia Capital

, is its chairman. He ousted Galloway from the board last year, after the co-founder led an unsuccessful shareholder revolt in the wake of a disastrous holiday season.

Moritz held sway in the proxy vote that followed RedEnvelope's 2004 shareholder's meeting, despite the admission that recent setbacks had been the result of mismanagement. His success was widely attributed to the power of management voting rights that go along with its reported 28% stake in the company. Still, the victors looked on the road to vindication after a successful holiday selling season in 2004.

For its fiscal third quarter, which includes the holiday season, RedEnvelope's profits doubled on a 32% jump in revenue, beating Wall Street's expectations. The news sent the stock, which lost 27% of its value in 2004, up 29% in the first two months of 2005. The euphoria came to an end in the fourth quarter, however, when the company suddenly lowered its earnings guidance.

Having originally predicted a break-even quarter, RedEnvelope ended with a wider loss than in its year-ago period. While revenue came in as expected, the company lost $3.9 million, or 43 cents a share. The downside was attributed to an inventory glut left over from its holiday season that wreaked havoc on gross margins as the retailer struggled to unload its leftover products.

"These guys are running around touting these big gross margins for the quarter, and a few weeks later they come out and say they're going to be 10 percentage points lower," Galloway said in an interview. "That's a huge miss. Clearly, they're not executing properly and they're not serving the best interests of the shareholders."

After RedEnvelope lowered its fourth-quarter guidance, it replaced its chief financial officer, Eric Wong, with Polly Boe, who served as chief financial officer for a direct retailer in Salt Lake City. It also added Joseph Gandolfo to its board. He served as


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president of global operations from 1990 to 2000.

Despite these additions, Galloway still contends that the company's management was too slow to act in the interest of shareholders. He said its missteps reflect a lack of experience in the retail industry.

While Moritz is legendary on Wall Street as a venture capitalist for his investments in highflying Internet companies such as



, his forays into online retailing have less luster. Moritz invested in a strong of retail flameouts, including eToys and WebVans.

"Just because you're successful as a venture capitalist in one sector doesn't mean you can effectively run a company in another," said Seider Cos. analyst Hank Wilson. (He does not own shares in RedEnvelope, and his company does not have an investment banking relationship.)

Wilson downgraded RedEnvelope from hold to sell last week after its earnings disappointment.

"Twelve months ago, RedEnvelope had a record of uneven financial results and earnings disappointments, a proxy fight was potentially looming over the company, and investor expectations were focused on an upcoming holiday season six months away," he wrote in a recent research note. "The company is virtually in the same position today."

Wilson also noted that he thinks investors may be more receptive to a coup led by Galloway this time around, but he sees little reason to own the stock at this point. Management has forecast positive net earnings in 2006 on revenue growth of at least 20%.

"This thing is basically a quarter-to-quarter story at this point," Wilson said in an interview with

. "It's a company with a lot of potential, but I see no real upside in the near future."