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UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, DC 20549
 Form 10-Q (Mark One)x
    
    QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934For the quarterly period ended June 27, 2004o
    
    TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934For the transition period from                                      to                                      .
 Commission File Number: 0-50387 RedEnvelope, Inc. (Exact Name of Registrant as Specified in Its Charter)
 Delaware
    
    33-0844285(State or Other Jurisdiction of
    
    (IRS EmployerIncorporation or Organization)
    
    Identification No.)
 201 Spear Street, 3rd Floor,
San Francisco, California 94105(Address of Principal Executive Offices and Zip Code) (415) 371-9100(Registrants Telephone Number, Including Area Code) Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirement for the past 90 days. Yes x  No o Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Exchange Act). Yes o  No x The number of outstanding shares of the registrants common stock, $0.01
par value per share, was 8,731,215 as of July 25, 2004.




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REDENVELOPE, INC.
REPORT ON FORM 10-Q
For the Quarter Ended June 27, 2004
TABLE OF CONTENTS PagePART I. FINANCIAL INFORMATIONItem 1.
    
    Financial Statements (Unaudited)Condensed Balance Sheets as of June 27,
2004, March 28, 2004 and June 29, 2003
    
    
    2Condensed Statements of Operations for
the thirteen weeks ended June 27, 2004
and June 29, 2003
    
    
    3Condensed Statements of Cash Flows for
the thirteen weeks ended June 27, 2004
and June 29, 2003
    
    
    4Notes to Condensed Financial Statements
    
    
    5Item 2.
    
    Managements Discussion and Analysis of
Financial Condition and Results of
Operations
    
    
    9Item 3.
    
    Quantitative and Qualitative Disclosures
About Market Risk
    
    
    29Item 4.
    
    Controls and Procedures
    
    
    30PART II. OTHER INFORMATION
    
    II-1Item 1.
    
    Legal Proceedings
    
    II-1Item 2.
    
    Changes in Securities, Use of Proceeds and Issues or Purchases of Equity Securities
    
    II-1Item 6.
    
    Exhibits and Reports on Form 8-K
    
    II-2EXHIBIT 10.40EXHIBIT 31.1EXHIBIT 31.2EXHIBIT 32.1EXHIBIT 32.2




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PART I.
FINANCIAL INFORMATION 
 Item 1.Financial Statements REDENVELOPE, INC. 
 CONDENSED BALANCE SHEETS (Unaudited)
 June 27,
    
    March 28,
    
    June 29,2004
    
    2004
    
    2003(In thousands, except per share data)ASSETSCurrent assets:Cash and cash equivalents
    
    $
    18,667
    
    
    $
    18,409
    
    
    $
    4,748Short-term investments
    
    
    10,495
    
    
    
    6,971
    
    
    
    Accounts receivable, net
    
    
    849
    
    
    
    1,055
    
    
    
    407Inventory
    
    
    8,275
    
    
    
    9,609
    
    
    
    7,095Prepaid catalog costs, other current assets and restricted cash
    
    
    1,792
    
    
    
    2,037
    
    
    
    1,232Total current assets
    
    
    40,078
    
    
    
    38,081
    
    
    
    13,482Property and equipment, net
    
    
    6,236
    
    
    
    4,746
    
    
    
    3,926Long-term investments
    
    
    
    
    
    
    1,844
    
    
    
    Other assets and restricted cash
    
    
    471
    
    
    
    505
    
    
    
    1,384Total assets
    
    $
    46,785
    
    
    $
    45,176
    
    
    $
    18,792LIABILITIES, MANDATORILY REDEEMABLE CONVERTIBLE
PREFERRED STOCK AND STOCKHOLDERS EQUITY/(DEFICIT)Current liabilities:Accounts payable
    
    $
    7,700
    
    
    $
    5,539
    
    
    $
    4,699Accrued expenses and other current liabilities
    
    
    3,228
    
    
    
    2,706
    
    
    
    1,840Accrued compensation
    
    
    1,215
    
    
    
    1,602
    
    
    
    627Capital lease obligations, current
    
    
    597
    
    
    
    596
    
    
    
    654Total current liabilities
    
    
    12,740
    
    
    
    10,443
    
    
    
    7,820Capital lease obligations, long-term
    
    
    671
    
    
    
    816
    
    
    
    980Total liabilities
    
    
    13,411
    
    
    
    11,259
    
    
    
    8,800Commitments and contingenciesMandatorily redeemable convertible preferred stock
    
    
    
    
    
    
    
    
    
    
    82,556Stockholders equity (deficit):Series A preferred stock, $0.01 par value; 2,000,000 shares
authorized, none, none, and 0.6 million issued and outstanding
as of June 27, 2004, March 28, 2004 and June 29, 2003,
respectively
    
    
    
    
    
    
    
    
    
    
    953Common stock, $0.01 par value; 100 million shares authorized;
8.7 million, 8.5 million, and 0.3 million issued and outstanding
as of June 27, 2004, March 28, 2004, and June 29, 2003,
respectively
    
    
    88
    
    
    
    86
    
    
    
    4Additional paid-in capital
    
    
    113,011
    
    
    
    112,728
    
    
    
    2,030Deferred compensation
    
    
    (71
    )
    
    
    (197
    )
    
    
    (766
    )Notes receivable from stockholders
    
    
    (44
    )
    
    
    (44
    )
    
    
    (44
    )Accumulated deficit
    
    
    (79,604
    )
    
    
    (78,652
    )
    
    
    (74,741
    )Accumulated other comprehensive loss
    
    
    (6
    )
    
    
    (4
    )
    
    
    Total stockholders equity/(deficit)
    
    
    33,374
    
    
    
    33,917
    
    
    
    (72,564
    )Total liabilities, mandatorily
redeemable convertible preferred
stock and stockholders
equity/(deficit)
    
    $
    46,785
    
    
    $
    45,176
    
    
    $
    18,792
 See accompanying notes to these condensed financial statements. 2




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REDENVELOPE, INC. 
 CONDENSED STATEMENTS
OF OPERATIONS
 (Unaudited)
 Thirteen Weeks EndedJune 27,
    
    June 29,2004
    
    2003(In thousands, except for per share data)Net revenues
    
    $
    21,131
    
    
    $
    17,721Cost of sales
    
    
    9,899
    
    
    
    9,050Gross profit
    
    
    11,232
    
    
    
    8,671Operating expenses:Fulfillment
    
    
    3,321
    
    
    
    2,713Marketing
    
    
    4,944
    
    
    
    3,747General and administrative
    
    
    3,915
    
    
    
    3,269Total
operating expenses
    
    
    12,180
    
    
    
    9,729Loss from operations
    
    
    (948
    )
    
    
    (1,058
    )Interest income
    
    
    75
    
    
    
    10Interest expense
    
    
    (79
    )
    
    
    (169
    )Net loss
    
    $
    (952
    )
    
    $
    (1,217
    )Net loss per share  basic and diluted
    
    $
    (0.11
    )
    
    $
    (3.52
    )Weighted average shares outstanding  basic and
diluted
    
    
    8,635
    
    
    
    346
 See accompanying notes to these condensed financial statements. 3




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REDENVELOPE, INC. 
 CONDENSED STATEMENTS
OF CASH FLOWS
 (Unaudited)
 Thirteen Weeks EndedJune 27,
    
    June 29,2004
    
    2003(In thousands)Cash Flows From Operating Activities:Net loss
    
    $
    (952
    )
    
    $
    (1,217
    )Adjustments to reconcile net loss to net cash used in operating activities:Depreciation and amortization
    
    
    618
    
    
    
    652Amortization of deferred stock compensation
    
    
    7
    
    
    
    28Other non-cash charges
    
    
    59
    
    
    
    Issuance of stock for services rendered
    
    
    
    
    
    
    9Changes in current assets and liabilities:Accounts receivable
    
    
    206
    
    
    
    (121
    )Inventory
    
    
    1,334
    
    
    
    2,621Other assets
    
    
    245
    
    
    
    355Accounts payable
    
    
    2,161
    
    
    
    (1,258
    )Accrued expenses and other current liabilities
    
    
    115
    
    
    
    301Net cash provided by operating activities
    
    
    3,793
    
    
    
    1,370Cash Flows From Investing Activities:Maturities of investments
    
    
    6,089
    
    
    
    Purchase of investments
    
    
    (7,772
    )
    
    
    Purchase of property and equipment
    
    
    (2,117
    )
    
    
    (116
    )Net cash used in investing activities
    
    
    (3,800
    )
    
    
    (116
    )Cash Flows From Financing Activities:Proceeds from exercise of common stock options and warrants
    
    
    410
    
    
    
    67Principal payments on capital lease obligations
    
    
    (145
    )
    
    
    (141
    )Repayment of loan
    
    
    
    
    
    
    (1,123
    )Payment of loan costs and other
    
    
    
    
    
    
    (306
    )Net cash provided (used) by financing activities
    
    
    265
    
    
    
    (1,503
    )Net increase (decrease) in cash and cash equivalents
    
    
    258
    
    
    
    (249
    )Cash and cash equivalents at beginning of period
    
    
    18,409
    
    
    
    4,997Cash and cash equivalents at end of period
    
    $
    18,667
    
    
    $
    4,748Supplemental Cash Flow Information:Cash paid for interest
    
    $
    39
    
    
    $
    66
 See accompanying notes to these condensed financial statements. 4




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REDENVELOPE, INC. 
 NOTES TO CONDENSED FINANCIAL STATEMENTS
(Unaudited) 1. Financial Statements  Basis of Presentation The accompanying unaudited financial statements include the accounts of
RedEnvelope, Inc. (referred to as the Company, we, us, and our). The
condensed balance sheets as of June 27, 2004 and June 29, 2003, the condensed
statements of operations for the thirteen-week periods ended June 27, 2004 and
June 29, 2003, and the condensed statements of cash flows for the thirteen-week
periods ended June 27, 2004 and June 29, 2003 have been prepared by us, without
audit. In our opinion, the financial statements include all adjustments (which
include only normal recurring adjustments) necessary to present fairly the
financial position at the balance sheet dates and the results of operations for
the thirteen-week periods then ended. The balance sheet at March 28, 2004, presented
herein, has been derived from the Companys audited balance sheet included in
the Companys Annual Report on Form 10K, for the fiscal year ended March 28,
2004. Certain information and disclosures normally included in the notes to the
annual financial statements prepared in accordance with accounting principles
generally accepted in the United States of America have been omitted. These
financial statements should be read in conjunction with the condensed financial
statements and notes thereto included in the Companys Annual Report on Form
10K, for the fiscal year ended March 28, 2004. Certain reclassifications have
been made to the prior period financial statements to conform to the
presentation used in the current period. The results of operations for the thirteen weeks ended June 27, 2004 are
not necessarily indicative of the operating results of the full year. Further,
the preparation of condensed financial statements requires management to make
estimates and assumptions that affect the recorded amounts reported therein. A
change in facts or circumstances surrounding the estimates could result in a
change to the estimates and impact future operating results. Our fiscal year ends on the Sunday closest to March 31, resulting in a 52
or 53 week year. Fiscal 2004 ended on March 28, 2004 and was 52 weeks long.
Fiscal 2005 will end on April 3, 2005 and will be 53 weeks long. We report our
interim results on a fiscal quarter basis rather than on a calendar quarter
basis. Under the fiscal quarter basis, each of the first three fiscal quarters
is thirteen weeks long, ending on the Sunday closest to the calendar quarter
end, with the fourth fiscal quarter covering the remaining part of the fiscal
year. 2. Accounting Policies Our financial statements have been prepared in accordance with accounting
principles generally accepted in the United States of America. The preparation
of these financial statements requires us to make estimates and judgments that
affect the reported amounts of assets, liabilities, revenues and expenses. We
base our estimates on historical experience and on various other assumptions
that we believe to be reasonable under the circumstances, the results of which
form the basis for making judgments about the carrying values of assets and
liabilities that are not readily apparent from other sources. Actual results
may differ from these estimates under different assumptions or conditions. Our
significant accounting policies are set forth below. Stock Based CompensationThe Company accounts for stock-based employee
compensation arrangements using the intrinsic value method in accordance with provisions of Accounting
Principles Board Opinion No. 25, Accounting for Stock Issued to Employees(APB
No. 25), and complies with the disclosure provisions of Statement of Financial
Accounting Standards (SFAS) No. 123, Accounting for Stock-Based Compensation
(SFAS No. 123) as amended by SFAS No. 148, Accounting for Stock-Based
Compensation  Transition and Disclosure (SFAS
No. 148). Under APB No. 25, compensation cost
is recognized based on the difference, if any, between the fair market value of
the Companys stock on the date of grant and the amount an employee must pay to
acquire the stock. Under SFAS 123, the fair value of stock-based awards to employees is calculated through the use of option pricing
models. Equity instruments issued to non-employees are accounted for
in accordance with the provision of SFAS No. 123 and Emerging Issues Task Force
Issue No. 96-18. 5




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The following table illustrates the effect on net loss
and loss per share as if we had applied the fair value recognition provisions of SFAS No. 123 as amended
by SFAS No. 148, to all our employee stock compensation arrangements: Thirteen Weeks EndedJune 27,
    
    June 29,2004
    
    2003(In thousands, except per share data)Net loss  as reported
    
    $
    (952
    )
    
    $
    (1,217
    )Stock-based employee compensation
included in reported net loss
    
    
    7
    
    
    
    39Stock-based compensation expense
determined under fair value base
method
    
    
    (144
    )
    
    
    (113
    )Pro forma net loss
    
    $
    (1,089
    )
    
    $
    (1,291
    )Basic and diluted loss per share:As reported
    
    $
    (0.11
    )
    
    $
    (3.52
    )Pro forma
    
    $
    (0.13
    )
    
    $
    (3.73
    )
 Loss Per ShareFor the thirteen weeks ended June 27, 2004 and June 29,
2003, basic net loss per share equals diluted net loss per share because the
effect of stock options, unvested shares and warrants outstanding would have
been antidilutive. The number of antidilutive stock options, unvested shares,
and warrants excluded from the calculation for the thirteen weeks ended June
27, 2004 and June 29, 2003, were approximately 1.1 million and 1.0 million,
respectively. For the thirteen weeks ended June 29, 2003, the effect of convertible
preferred stock was excluded from the computation of loss per share, as the
effect was antidilutive. The weighted average shares of common stock issuable
from conversion of convertible preferred stock was approximately 6.0 million. Comprehensive LossTotal comprehensive loss for the
period ended June 27, 2004 totalled $958 thousand. Comprehensive loss consists of two components, net
loss and other comprehensive loss. Other comprehensive loss refers to revenue,
expenses, gains and losses that under generally accepted accounting principles
are recorded as an element of stockholders equity but are excluded from net
loss. The Companys other comprehensive loss for the period
ended June 27, 2004 is comprised of unrealized losses
of $6 thousand on marketable securities categorized as available-for-sale. New Accounting PronouncementsIn May 2003, the FASB issued SFAS No. 150,
Accounting for Certain Financial Instruments with Characteristics of both
Liabilities and Equity. SFAS No. 150 requires instruments that are mandatorily
redeemable, among other financial instruments, which embody an unconditional
obligation requiring the issuer to redeem them by transferring its assets at a
specified or determinable date or upon an event that is certain to occur, be
classified as liabilities. The adoption of this statement during fiscal 2004
did not have an impact on the Companys financial statements. In December 2003, the Financial Accounting Standards Board published
a revision to Financial Interpretation No. 46 (FIN 46),
Consolidation of Variable Interest Entities (hereafter
referred to as FIN 46R) to clarify some of the provision
of FIN 46, and to exempt certain entities from its requirements.
Under the new guidance, there are new effective dates for companies that have interest in structures that are commonly
referred to as special-purpose entities. The rules are effective in financial statements for periods
ending after March 15, 2004. FIN 46R did not have any impact on our operating results or financial position
as we do not have any variable interest entities. In March 2004, the Emerging Issues Task Force (EITF) reached a consensus
on Issue No. 03-1, The Meaning of Other-Than-Temporary
Impairments and Its Application to Certain Investments
(EITF 03-1). EITF 03-1 provides a three-step impairment model for determining whether an investment is other-than-temporarily
impaired and requires the Company to recognize such impairments as an impairment loss equal to the difference between the
investments cost and fair value at the reporting date. The
guidance is effective for periods ending after June 15, 2004. The Company does not believe that the adoption of EITF 03-1 will have
a significant effect on its financial statements. 3. Investments Short-term investments consist of government securities and corporate
bonds both with maturities beyond three months but less than one year. Long
term investments consist of corporate bonds with maturities of one year or
longer. 6




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All of the Companys investments are considered available-for-sale. Such
securities are carried at fair market value. Fair value is based on market
quotes. Unrealized gains and losses, net of tax, on securities in this category
are reported as a separate component of stockholders equity. The cost of
securities sold is based on the specific identification method. Interest earned
on securities is included in interest income. Available-for-sale investments at June 27, 2004 were as follows (in
thousands): Corporate bonds and auction preferred stock (short-term)
    
    $
    7,235Government securities (short-term)
    
    
    3,260Total available-for-sale investments
    
    $
    10,495
 There were no gross realized gains or losses the thirteen weeks ended June
27, 2004 and the gross realized gains or losses for the thirteen weeks ended
June 29, 2003 were immaterial. The
contractual maturity of all available-for-sale investments was less
than one year at June 27, 2004. 4. Borrowing Arrangements The Company has a line of credit from CapitalSource Finance LLC. Per the
terms of this agreement, CapitalSource Finance LLC has made available to the
Company a credit facility under a revolving promissory note with a maximum
principal amount of $11.0 million, subject to availability guidelines that
specify the amount that can be borrowed under the facility at any given time.
Amounts borrowed under this line of credit bear interest at rates equal to the
greater of 9.5% or the prime lending rate plus 5.75%, for advances up to a
fluctuating base amount, and equal to the greater of 11.5% or the prime lending
rate plus 7.75% for advances in excess of that base amount. Amounts borrowed
under this line of credit are secured by substantially all of the Companys
assets. The line of credit agreement provides for certain events of default,
sets forth a number of affirmative and negative covenants to which the Company
must adhere and expires on April 15, 2006. The Company must pay an unused line
fee of up to $0.05 million per year, which is payable monthly, based on the
unused portion of the loan commitment. The Company has borrowed funds under
this credit facility from time to time and periodically repaid such borrowings
with available cash. There were no borrowings outstanding during the quarter
ended June 27, 2004. On June 21, 2004, the Company amended the terms of its credit facility
with CapitalSource Finance LLC. Under the terms of this Second Amendment,
certain covenants for inventory ratios and capital expenditure limitations were
eliminated. The minimum earnings before interest, taxes, depreciation and
amortization (EBITDA) covenant was modified, and quarterly minimum unrestricted
cash balance levels were established. Further, under this Second Amendment, the
EBITDA and minimum unrestricted cash balance covenants were modified such that
they are not applicable unless borrowings are outstanding. In advance of any borrowings, the Company is required to deliver to
CapitalSource Finance LLC written notification of its intent to borrow, certain
consents from the Companys landlords and credit card processing firm, a list
of domain name registrations, evidence of compliance with EBITDA and minimum
unrestricted cash balance levels on a prospective basis, and historical and
prospective financial statements. In addition, CapitalSource Finance LLC may
perform due diligence on the Companys financial projections. 7




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Events of default under this credit agreement include, subject to grace
periods and notice periods in certain circumstances, failure to pay any amount
owed under the line of credit when due, breach of representations contained in
the agreement, failure to perform covenants contained in the agreement,
termination of any loan document or security interest created under the
agreement, a judgment against the Company in excess of certain amounts, failure
to pay certain amounts of indebtedness due under, or another default under,
debt or other agreements to which the Company is party, insolvency or petition
for bankruptcy or dissolution, certain defined change of control transactions,
the termination of the employment of the Companys Chief Executive Officer or
Brand Strategist if not timely replaced by suitable successors, a material
adverse effect on the Companys business or material adverse change in the
validity of the credit agreement, the value of the Companys assets that are
pledged as collateral or the Companys business, operations, prospects,
properties, assets, liabilities or condition, the occurrence of an uninsured
casualty loss in excess of certain amounts, indictment or conviction of any
director or senior officer of a felony or a levy, attachment or garnishment
that could lead to forfeiture of collateral under the agreement. The credit agreement requires us to pay and deliver all collections to an
account over which CapitalSource Finance LLC has sole control. When we borrow
under the credit agreement, the borrowings are repaid through the funds in this
account. Under the terms of the Second Amendment, if the Company is not
borrowing, this account will not be utilized. As a result, funds settled from
our net revenues will be deposited directly into our bank account as long as no
amounts are outstanding under the credit agreement. In addition, the credit agreement requires, subject to exceptions in
certain limited circumstances, maintaining excess availability of a certain
amount of capital at certain specified times, a covenant which among other
things restricts the Companys ability to engage in certain acquisition and
investment transactions, and other covenants which restrict or place
limitations on the Companys ability to incur indebtedness, issue securities,
create or allow to exist any liens on the Companys assets, transfer the
Companys assets, or declare or pay dividends. As of June 27, 2004, the Company did not have an outstanding balance under
this credit facility. 5. Commitment In July 2004, the Company entered into an operating lease
agreement for 28,000 square feet of office space for our headquarters in San Francisco, California. The lease term is five
years with one option to extend for additional two years and another
option to extend for an additional five years. The monthly lease
commitment is approximately $52 thousand which is approximately the same as the current office lease amount which
expires in September 2004. 6. Legal Proceedings By its letter dated March 9, 2000, Red Letter Days Plc, a United Kingdom
company (Red Letter Days), asserted trademark rights in the United Kingdom in
the marks RED LETTER, RED LETTER DAYS and the image of a red envelope. Red
Letter Days offers experiential gifts in the United Kingdom. The letter claimed
that if we were to use our name and the REDENVELOPE service mark in the United
Kingdom in connection with retail sales of gifts, it would infringe Red Letter
Days trademark rights. We have made a number of attempts to reach an amicable
resolution of this dispute, but Red Letter Days has declined, to date, to enter
into settlement negotiations. Red Letter Days has opposed our applications to
register the REDENVELOPE and RedEnvelope stylized logo marks in the United
Kingdom and the European Community. Red Letter Days oppositions to our United
Kingdom and European Community trademark applications are pending. Evidentiary
submissions have been made by the parties in connection with those opposition
proceedings and a decision is not expected for several months. The sole issue
to be decided in the opposition proceedings is whether the REDENVELOPE mark is
entitled to registration in the stated jurisdictions. Even if an opposition is
successful in preventing the subject trademark from being registered, that
decision by the registration authorities does not prevent the applicant from
using the mark in that jurisdiction. In order to prevent us from using the
RedEnvelope mark in the United Kingdom or European Community or to obtain any
other equitable relief or monetary relief, Red Letter Days would need to bring
a lawsuit against us in the appropriate jurisdiction. To the best of our
knowledge, no such lawsuit has been filed. We opposed Red Letter Days
application to register the RED LETTER mark in the United Kingdom, based on the
descriptiveness of the RED LETTER mark as applied to the services of Red Letter
Days. The United Kingdom trademark office has denied our opposition and has
approved the registration of the Red Letter Days mark in the United Kingdom.
This decision did not address a comparison of the REDENVELOPE and RED LETTER
marks. On September 3, 2003, Activ8now, LLC filed a patent infringement lawsuit
against the Company in the United States District Court, Northern District of
Georgia. The lawsuit alleged a cause of action for infringement of U.S. Patent
Nos. 6,535,889 and 6,557,006 based on the theory that certain of our website
operations were covered by such patents. On June 18, 2004, the Company and
Activ8now, LLC entered into a settlement agreement providing the Company with a
non-exclusive, irrevocable, paid-up, worldwide license to such patents in
exchange for a one-time fee and dismissal of the lawsuit with prejudice. The
settlement did not have a material adverse effect on the Companys financial
position or results of operations. From time to time, the Company is subject to legal proceedings and claims
in the ordinary course of business, including claims of alleged infringement of
trademarks and other intellectual property rights. The Company is not currently
aware of such legal proceedings or claims that it believes will have,
individually or in the aggregate, a material adverse effect on its financial
position or results of operations. 8




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Item 2. Managements Discussion and Analysis of Financial Condition and Results of Operations The following discussion should be read in conjunction with the unaudited
condensed financial statements and the notes thereto included in Item 1 of this
Quarterly Report on Form 10-Q. Forward-Looking Statements This report, together with the documents incorporated herein by reference,
contains forward-looking statements within the meaning of Section 27A of the
Securities Act of 1933, as amended, and Section 21E of the Securities and
Exchange Act of 1934, as amended. Such statements are based upon current
expectations and involve risks and uncertainties. Any statements contained in
this report that are not purely statements of historical fact may be deemed to
be forward-looking statements. Such forward-looking statements may include but
are not limited to statements regarding our future operations and enhancements,
product offerings, business, financial condition, results of operations and
prospects. Additionally, statements concerning possible changes in applicable
rules or legislation are forward-looking statements. Words such as expects,
anticipates, intends, plans, believes, seeks, estimate, may,
should, could and similar expressions or variations of such words are
intended to identify forward-looking statements, but are not the exclusive
means of identifying forward-looking statements in this report. All
forward-looking statements in this report are based upon information available
to us as of the date hereof, and we assume no obligation to revise or update
any such forward-looking statements in order to reflect any event or
circumstance that may arise after the date of this report. Actual results and
the timing of certain events could differ materially from our current
expectations. Factors that could cause or contribute to such differences
include, but are not limited to, those set forth in this report under Factors
That May Affect Future Results, and elsewhere in this report, and those
contained from time to time in our other filings with the SEC. We caution
investors that our business and financial performance are subject to
substantial risks and uncertainties. Overview During the first quarter of fiscal 2005, we continued our efforts around
our three strategic initiatives for fiscal 2005: improving the operational
execution throughout our supply chain including our fulfillment center,
expanding our marketing campaigns and continued development and expansion of
our unique and proprietary product assortments. While the benefits from these
initiatives are currently anticipated to occur over the remaining quarters, we
believe these investments in our business are vital to support the future
growth of the Company. Our net revenues increased 19.2% from the first quarter of fiscal 2004 to
$21.1 million in the first quarter of fiscal 2005. Gross margins in the first
quarter of fiscal 2005 increased to 53.2% from 48.9% in first quarter of fiscal
2004. Net loss as a percentage of net revenues decreased from (6.8%) in the
first quarter of fiscal 2004 to (4.5%) in the first quarter of fiscal 2005. We also continued to emphasize improving our order fulfillment rates at our
fulfillment center. Based on internal quality control sampling, we processed
orders during the Mothers Day and Fathers Day events with approximately 99%
accuracy. We were able to offer one-day turnaround time for personalized orders
during these events. To further enhance our operational execution, we
continued our projects related to a new warehouse management system and
investment into our materials handling processing. As a result of the projects,
certain team members at the fulfillment center were required to participate in
the development and implementation efforts. Consequentially, we incurred more
seasonal labor costs. If we are unable to improve the performance of the
fulfillment process at our fulfillment center, we may incur additional labor
and shipping costs, fail to satisfy demand for our products or experience
customer dissatisfaction, any of which could have an adverse affect on our
business, financial condition, and operating results. Achieving operational
effectiveness at times of peak demand will continue to be a critical area of
management focus. During the quarter, we increased our marketing efforts to acquire
customers primarily through our catalog campaigns. As a result, our revenues
from existing customers decreased slightly to 52% in the first quarter of
fiscal 2005 from 55% in the first quarter of fiscal 2004. Our internal database
of customer names (customers who have purchased from the Company in the past) increased to approximately 1.9 million, with approximately
0.1 million new customers names added in the first quarter of fiscal 2005. We intend
to increase loyalty from existing customers by offering unique and innovative
products, helpful and knowledgeable customer service, accurate fulfillment
rates and targeted marketing programs. 9




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Our merchandising strategy continues to emphasize the development of
unique products that are difficult to find elsewhere in the marketplace. For
each of Mothers Day and Fathers Day, 35% of our top 20 best sellers were designed in-house. We also offered a growing number of products that are exclusive to the
Company. For Mothers Day and Fathers Day 65% and 80%, respectively, of our top 20 best sellers were exclusive to
the Company. Although we are committed to our strategic initiatives, there are inherent
risks associated with our business that may present challenges for us in the
future and could prevent us from achieving intended revenue growth, scalability
and increased efficiencies. We have outlined currently identified risks within
the Factors That May Affect Future Results section of this report. In
addition, the following discussion and analysis of financial condition, results
of operations, liquidity and capital resources should be read in conjunction
with our audited financial statements and the notes thereto. Critical Accounting Policies Our financial statements have been prepared in accordance with accounting
principles generally accepted in the United States of America. The preparation
of these financial statements requires us to make estimates and judgments that
affect the reported amounts of assets, liabilities, revenues and expenses. We
base our estimates on historical experience and on various other assumptions
that we believe to be reasonable under the circumstances, the results of which
form the basis for making judgments about the carrying values of assets and
liabilities that are not readily apparent from other sources. Actual results
may differ from these estimates under different assumptions or conditions. Our
critical accounting policies are set forth below. Revenue recognition.We derive our revenues from merchandise sales made to
consumers and businesses. We generally require payment by credit card prior to
shipment. We recognize revenue on the date on which we estimate that the
product has been received by the customer and any payments received prior to
the estimated date of receipt of the goods by the customer are deferred. We use
our third-party freight carrier information to estimate when delivery has
occurred. Revenues are recorded net of estimated returns, coupons redeemed by
customers, and other discounts. Significant management judgments and estimates
must be made and used in connection with determining revenue recognized in any
accounting period. In particular, our management must make estimates of
potential future product returns related to current period revenue. We analyze
historical returns, current economic trends and changes in customer demand and
acceptance of our products when evaluating the adequacy of the sales returns
and other allowances in any accounting period. Actual returns may differ
materially from our estimated reserve. As a result, our operating results and
financial condition could be affected adversely. The reserve for returns was
$0.4 million, $0.2 million and $0.2 million as of June 27, 2004, March 28, 2004
and June 29, 2003, respectively. Shipping and Handling Costs.Shipping costs, which include inbound and
outbound freight costs and the cost of gift wrap, are included in cost of
sales. Handling costs, which include fees paid to our former third-party
fulfillment service provider as well as distribution center expenses, are included in
operating expenses  fulfillment. Handling costs included in operating expenses
 fulfillment for the thirteen weeks ended June 27, 2004 and June 29, 2003 were
$1.2 million and $1.1 million, respectively. Our gross profit may not be
comparable to other entities, which may allocate all shipping and handling
costs to either cost of sales, resulting in lower gross profit, or to operating
expenses, resulting in higher gross profit. Inventory.Inventories are stated at the lower of cost or market. We
estimate a provision for damaged, obsolete, excess and slow-moving inventory
based on inventory aging reports and specific identification. If actual
obsolescence is different from our estimate, we will adjust our provision
accordingly. Specific provisions are recorded in the event the cost of the
inventory exceeds the fair market value. In addition, we estimate a reserve for
expected inventory shrinkage based on historical shrinkage factors and our
current inventory levels. Actual shrinkage is recorded at fiscal year-end based
on the results of our physical inventory count. The obsolescence reserve was
$0.6 million, $0.3 million and $0.7 million as of June 27, 2004, March 28, 2004
and June 29, 2003, respectively. Accounting for income taxes.Significant management judgment is required
in determining our deferred tax assets and liabilities and any valuation
allowance recorded against our net deferred tax assets. As of March 28, 2004,
we had recorded a valuation allowance of $28.0 million against our net deferred
tax asset balance due to uncertainties related to our deferred tax assets as a
result of our history of operating losses. The valuation allowance is based on
our estimates of taxable income by jurisdiction in which we operate and the
period over which our 10




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deferred tax assets will be recoverable. In the event that actual results
differ from these estimates or we adjust these estimates in future periods, we
may need to change the valuation allowance, which could materially impact our
financial position and results of operations. Catalog Amortization.Prepaid catalog costs consist of third-party costs
including paper, printing, postage and mailing costs for all of our direct
response catalogs. Such costs are capitalized as prepaid catalog costs and are
amortized over their expected period of future benefit which generally does not
exceed two months. Such amortization is based upon the ratio of actual revenues
to the total of actual and estimated future revenues on an individual catalog
basis. Prepaid catalog costs are evaluated for realizability at each reporting
period by comparing the carrying amount associated with each catalog to the
estimated probable remaining future net benefit of the catalog (defined as net
revenues less merchandise cost of goods sold, selling expenses and catalog
completion costs) associated with that catalog. If the carrying amount is in
excess of the estimated probable remaining future net benefit of the catalog,
the excess is expensed in the reporting period. Valuation of long-lived assets.Long-lived assets held and used by us are
reviewed for impairment whenever events or changes in circumstances indicate
the net book value may not be recoverable. An impairment loss is recognized if
the sum of the expected future cash flows from use of the asset is less than
the net book value of the asset. The amount of the impairment loss will
generally be measured as the difference between net book values of the assets
and their estimated fair values. Our estimate of undiscounted future cash flows
is based upon our experience, historical operations, estimates of future
profitability and economic conditions. Stock based compensation.We account for stock options granted to
employees using the intrinsic value method in accordance with Accounting
Principles Board Opinion No. 25, Accounting for Stock Issued to Employees.
Accordingly, no compensation expense has been recognized in the financial
statements for stock options. SFAS No. 123, Accounting for Stock-Based
Compensation, as amended by SFAS No. 148, Accounting for Stock-Based
Compensation  Transition and Disclosure, however, requires the disclosure of
pro forma net earnings and earnings per share as if we had adopted the fair
value method. Under SFAS No. 123, the fair value of stock-based awards to
employees is calculated through the use of option pricing models. These models
require subjective assumptions, including future stock price volatility and
expected time to exercise, which affect the calculated values. Our calculations
are based on a single option valuation approach and forfeitures are recognized
as they occur. In fiscal 2000, we granted approximately 0.4 million options to employees
at an exercise price that was less than the fair market value of our stock on
the date of grant. We recorded $1.8 million of deferred compensation related to
these option grants, which is included as a separate component of stockholders
equity, and is being amortized over the vesting period of the awards. We
recorded amortization expense of $39,000 for the thirteen weeks ended June 29,
2003, which is included in general and administrative expenses in the
statements of operations. There was no amortization expense recorded during
the quarter ended June 27, 2004. In fiscal 2004, we granted approximately 0.3 million options to employees
at an exercise price that was less than the fair market value of our stock on
the date of grant. We recorded $0.7 million of deferred compensation related to
these option grants, which is included as a separate component of stockholders
equity, and is being amortized over the vesting period of the awards. We
recorded amortization expense of $7,000 for the thirteen weeks ended June 27,
2004, which is included in general and administrative expenses in the
statements of operations. Results of Operations The following table sets forth our statements of operations data for the
thirteen weeks ended June 27, 2004 and June 29, 2003, respectively, expressed
as a percentage of net revenues. 11




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Thirteen WeeksJune 27,
    
    June 29,2004
    
    2003Statements of Operation Data:Net revenues
    
    
    100.0
    %
    
    
    100.0
    %Cost of sales
    
    
    46.8
    
    
    
    51.1Gross profit
    
    
    53.2
    
    
    
    48.9Operating expenses:Fulfillment
    
    
    15.7
    
    
    
    15.3Marketing
    
    
    23.4
    
    
    
    21.1General and administrative
    
    
    18.5
    
    
    
    18.4Total operating expenses
    
    
    57.6
    
    
    
    54.8Loss from operations
    
    
    (4.4
    )
    
    
    (5.9
    )Interest income
    
    
    0.3
    
    
    
    0.1Interest expense
    
    
    (0.4
    )
    
    
    (1.0
    )Net loss
    
    
    (4.5
    )%
    
    
    (6.8
    )%
 Revenues Our net revenues are comprised of product sales, shipping revenue and
gift-wrap revenue. Revenues are recorded net of estimated returns, coupons
redeemed by customers, and other discounts. Our shipping revenue represents the
amounts we charge our customers for delivering the product. Our gift wrap
revenue consists of amounts we charge our customers for our signature red gift
boxes. Net revenues were $21.1 million and $17.7 million for the thirteen weeks
ended June 27, 2004 and June 29, 2003, respectively, representing a 19.2%
increase. The increase was primarily due to increased demand for our products
resulting from additional marketing efforts through our online and catalog
campaigns. Online revenues, through search, portals, and affiliates, grew 20.8%
over the same quarter in the prior year. Revenues from customers who receive
our catalogs grew 29.0% over the first quarter of fiscal 2004. During the first
quarter of fiscal 2005, we increased our catalog circulation by approximately
1.1 million catalogs, or 22.6%. The number of orders increased by approximately
14.8% over the first quarter of fiscal 2004, primarily as a result of the
increased catalog circulation. Net revenues per order increased by approximately 3.9%
over the first quarter of fiscal 2004 due to increased customer demand for some
of the higher priced items within our home, children and womens accessories
product categories. In August of 2003, we changed the delivery charge for
standard ground delivery to a flat rate regardless of order value. As a result,
our shipping revenues decreased in the first quarter of fiscal 2005 compared to
the first quarter of fiscal 2004. Our customer base increased from
approximately 1.8 million at the end of fiscal 2004 to approximately 1.9
million at the end of the first quarter of fiscal 2005. Cost of Sales Cost of sales consists of the cost of the product sold, inbound and
outbound freight and gift-wrap expense. Shipping costs, which include inbound
and outbound freight, and the cost of gift wrap are also included in cost of
sales. Handling costs, which include fees paid to our former third-party
fulfillment service provider and fulfillment center expenses, are included in
operating expenses  fulfillment. Cost of sales were $9.9 million and $9.1 million for the thirteen weeks
ended June 27, 2004 and June 29, 2003, respectively, representing 46.8% and
51.1% of net revenues respectively. The 9.4% increase in costs of sales was
mainly attributable to the 19.2% increase in net revenues. The decrease in cost
of sales as a percentage of net revenues was primarily attributable to higher
average product margins resulting from an increase in overseas product
sourcing, which typically has lower product costs. 12




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Operating Expenses Fulfillment.Fulfillment expenses consist of wages and benefits for
employees and seasonal hires working in our distribution center and customer
service facility, fees incurred to process credit card transactions and certain
fixed costs, such as rent and utilities, incurred by our distribution center
and customer service facility. Prior to August 2003, fulfillment expenses also
included fees paid to our former third-party fulfillment service provider.
Services performed by our former third-party fulfillment service provider
included receiving, picking, packing, shipping and other warehousing
activities. Fulfillment expenses were $3.3 million and $2.7 million for the thirteen
weeks ended June 27, 2004 and June 29, 2003, respectively, representing 15.7%
and 15.3% of net revenues, respectively. The increase in dollars and percentage
of net revenues was primarily attributable to the 14.8% increase in the number
of orders. In addition, we incurred certain preparation and training costs
related to our new warehouse management systems and the revision of certain
materials handling processes at the fulfillment center in connection with our initiative to improve the operational execution throughout our
supply chain. As a result of improved order fulfillment rates, our customer
service center was able to focus on phone calls for order placing and less
resources were needed for phone calls associated with order fulfillment
inaccuracies. In addition, our return rates in the first quarter of fiscal 2005
improved compared to the first quarter of fiscal 2004. We are in the process of revising certain materials handling processes and
implementing new warehouse management software, which we believe will allow us
to better manage our fulfillment operations and scale our business. If we are
unable to improve the performance of the fulfillment process at our
distribution center or if our planned modifications cost more than we
anticipate, our operating results could be materially harmed. Marketing.Marketing expenses consist primarily of online and catalog
programs as well as advertising, public relations, and other promotional
expenditures. Marketing expenses were $4.9 million and $3.7 million for the thirteen
weeks ended June 27, 2004 and June 29, 2003, respectively, representing 23.4%
and 21.1% of net revenues, respectively. The increase in dollars and percentage
of net revenues was primarily due to additional spending in our online and
catalog advertising campaigns. During the first quarter of fiscal 2005, we
increased our catalog circulation by approximately 1.1 million catalogs, or
22.6%, over the first quarter of fiscal 2004. Currently, we plan on increasing
the circulation of our Basics and Fall catalogs for the next fiscal quarter. In
addition, we incurred costs related to marketing studies and agency fees
related to our upcoming advertising campaigns. These costs were incurred in
advance of the expected revenue stream from our advertising campaigns. In addition, we plan to increase our marketing through print and outdoor
advertising campaigns. As a result, we anticipate the costs of marketing to increase compared to the prior fiscal year.
The print and outdoor advertising campaigns are expected to begin in the second
half of our 2005 fiscal year. In addition, the costs to develop these marketing
campaigns will be made in advance of the expected revenue stream. We are also
currently developing a catalog for corporate gift-giving that includes specific
products and creative marketing designed for the corporate customer. If we are
unsuccessful in generating sufficient revenues through these marketing
vehicles, our operating results could be adversely affected. General and Administrative.General and administrative expenses consist of
wages and benefits for our administrative employees, located primarily at our
corporate office. These expenses also include costs incurred for computer and
communications technology, rent and utilities for our headquarters, travel,
depreciation, and other general corporate expenditures. General and administrative expenses were $3.9 million and $3.3 million for
the thirteen weeks ended June 27, 2004 and June 29, 2003, respectively,
representing 18.5% and 18.4% of net revenues, respectively. The increase was
primarily due to training and consulting fees related to our software and systems implementations projects,
personnel related costs and the costs associated with being a publicly-held
company. The planned implementation of new software systems in fiscal year 2005
will result in additional depreciation expense. We also currently plan on
increasing our general and administrative employee headcount (i.e., employees
other than fulfillment and customer service employees) in order to support
future business needs, which will add to general and administrative expenses.
Also, the compliance requirements associated with being a public company will
likely increase our accounting and legal expenses. In addition, we currently anticipate incurring additional costs, such as legal and
proxy solicitation fees, related to our 2004 Annual Meeting and Proxy. As a result of the
solicitation of proxies by a group of stockholders, the Companys expenses related to its
solicitation of proxies will exceed those normally spent for an annual meeting. 13




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Other Income and Expenses Interest Income.Interest income was $0.07 million and $0.01 million in
the thirteen weeks ended June 27, 2004 and June 29, 2003 respectively. The
increase is primarily due to higher average cash balances and slightly higher
interest rates. Interest Expense.Interest expense was $0.08 million and $0.2 million in
the thirteen weeks ended June 27, 2004 and June 29, 2003, respectively. The
decrease is primarily attributable to lower amounts of debt outstanding. Liquidity and Capital Resources We have funded our operations primarily through private sales of equity
securities, borrowings, and the completion of our initial public offering which
resulted in net offering proceeds of approximately $29.0 million. Historically,
revenues have been seasonal. Revenues have been higher in the third fiscal
quarter, reflecting higher consumer holiday spending. As a result, our cash
balances are seasonal in nature, with the third fiscal quarter representing a
significantly higher level of cash than other periods. Throughout the fiscal
year, we utilize our cash balances to build our inventory levels with the most
significant use of working capital occurring immediately prior to the month of
December. In addition to our current cash balances on-hand, we have an $11.0
million revolving credit facility which allows us to borrow funds for working
capital purposes, subject to certain provisions. Cash Flows From Operating Activities Net cash flows provided by operating
activities were $3.8 million and $1.4 million for thirteen weeks ended June 27,
2004 and June 29, 2003 respectively. In the first quarter of fiscal 2005, net
cash provided by operating activities increased by $2.4 million from the first
quarter of fiscal 2004, resulting primarily from changes in working capital and
lower net loss. Specifically, there was an increase in our accounts payable
and a decrease in our merchandise inventories. This was primarily due to the
timing of seasonal inventory receipts and payable disbursements. Cash Flows From Investing Activities Net cash flows used in investing
activities were ($3.8) million and ($0.1) million for thirteen weeks ended June
27, 2004 and June 29, 2003 respectively. Uses of cash flow from investing
activities consisted of capital expenditures for property and equipment
purchases and maturities of investments. Currently, we are planning capital expenditures for
software systems to support our financial, warehouse management, and order
management functions. We believe the implementation of these software systems
will support the needs of our business and customers. Software implementation
projects entail significant technical and business risks. If we are
unsuccessful in implementing these systems, it may hinder our ability to
process and fulfill customer orders as well as complete critical financial
processing transactions. These capital expenditures will result in an increase
in our depreciation expense. For the thirteen weeks ended June 27, 2004, we
have spent approximately $1.7 million for our warehouse management system,
materials handling equipment, and order management system projects. We
currently estimate spending between $1.0 million and $1.2 million over the
remaining fiscal year 2005 on our warehouse management system, materials
handling equipment, and order management system projects. Although we believe
these estimates on expenditures to be reasonable given the current facts and
circumstances available to us, we can offer no assurance that the actual
amounts expended will not be greater. Cash Flows From Financing Activities Net cash flows provided by (used
in) financing activities were $0.3 million and ($1.5) million for the thirteen
weeks ended June 27, 2004 and June 29, 2003 respectively. For the first quarter
of fiscal 2005, net cash flows from financing activities consisted of proceeds
from the exercises of stock options which were slightly offset by payments for
capital lease obligations. Revolving Credit Facility We also have funds available of up to $11
million pursuant to our revolving credit facility with CapitalSource Finance
LLC, which is described more fully in Note 4 to the financial statements
contained in this report. Our ability to borrow under this credit facility is
subject to compliance with its terms. At June 27, 2004, we had no borrowings
under the revolving credit facility. 14




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On June 21, 2004, the Company amended the terms of its credit facility
with CapitalSource Finance LLC. Under the terms of this Second Amendment,
certain covenants for inventory ratios and capital expenditure limitations were
eliminated. The minimum earnings before interest, taxes, depreciation and
amortization (EBITDA) covenant was modified, and quarterly minimum unrestricted
cash balance levels were established. Further, under this Second Amendment, the
EBITDA and minimum unrestricted cash balance covenants were modified such that
they are not applicable unless borrowings are outstanding. CapitalSource
Finance LLC previously has waived non-compliance with such covenants as of
prior dates, be we can offer no assurance that they will do so in the future. In advance of any borrowings, the Company is required to deliver to
CapitalSource Finance LLC written notification of its intent to borrow, certain
consents from the Companys landlords and credit card processing firm, a list
of domain name registrations, evidence of compliance with EBITDA and minimum
unrestricted cash balance levels on a prospective basis, and historical and
prospective financial statements. In addition, CapitalSource Finance LLC may
perform due diligence on the Companys financial projections. In July 2004, we entered into an operating lease agreement for 28,000
square feet of office space for our headquarter in San Francisco, California. Our current headquarters lease expires in September 2004.
The new monthly lease commitment is approximately the same as the current office lease amount. We believe that the cash currently on hand will be sufficient to continue
operations through at least the next twelve months. Our assessment is based on
historical working capital needs, operating loss trends, and current business
outlook. Beyond the next twelve months, we intend to utilize the cash generated
from operations to fund operations and capital expenditures. We may, in the
future, be required to raise funds through additional equity and /or debt
financings to support our long-term obligations and needs. However, there can
be no assurance that if additional financing is necessary it will be available,
or if available, that such financing can be obtained on satisfactory terms or
without undue dilution to, or an adverse impact on the rights of, our existing
stockholders. Failure to generate sufficient revenues or raise additional
capital could have a material adverse effect on our ability to continue as a
going concern and to achieve our intended business objectives.  Factors That May Affect Future Results
 You should consider carefully the risks and uncertainties relating to our
business described below. Additional risks and uncertainties not currently
known to us or that we currently do not deem material may also become important
factors that may harm our business. The trading price of our common stock could
decline due to any of these risks and uncertainties. Our limited operating history makes evaluation of our business difficult. We were originally incorporated in 1997 and began selling products in
September 1997. As a result, we have limited historical financial data upon
which to base planned operating expenses or forecast accurately our future
operating results. Further, our limited operating history will make it
difficult for investors and securities analysts to evaluate our business and
prospects. You must consider our business and prospects in light of the risks
and difficulties we may face as an early stage company with limited operating
history. These risks and difficulties include challenges in accurate financial
planning as a result of limited historical data and the uncertainties resulting
from having had a relatively limited time period in which to implement and
evaluate our business strategies as compared to older companies with longer
operating histories. Our failure to successfully address these risks and
difficulties would seriously harm our business. We have a history of significant losses. If we do not achieve or sustain
profitability, our financial condition and stock price could suffer. We have a history of losses and we may continue to incur losses for the
foreseeable future. As of June 27, 2004, our accumulated deficit was $79.6
million. We have not achieved profitability for a full fiscal year. If our
revenues grow more slowly than we anticipate, or if our operating expenses
exceed our expectations, we may not be able to achieve profitability in the
near future or at all. Even if we do achieve profitability, we may not be able
to sustain or increase profitability on an annual basis in the future. If we
are unable to achieve profitability within a short period of time, or at all, or if we are unable to sustain profitability at
satisfactory levels, our financial condition and stock price could be adversely
affected. 15




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Because we experience seasonal fluctuations in our net sales, our quarterly
results will fluctuate and our annual performance will depend largely on
results from one quarter. Our business is highly seasonal, reflecting the general pattern of peak
sales for the retail industry during the holiday shopping season. Typically, a
substantial portion of our net revenues occur during our third fiscal quarter
ending around December 31. We generally experience lower net revenues during
the first, second and fourth fiscal quarters and, as is typical in the retail
industry, have incurred and may continue to incur losses in these quarters. The
third fiscal quarter accounted for approximately 45% of net revenues in the
fiscal year ended March 28, 2004. We cannot predict with certainty what
percentage of our total net revenues for fiscal year 2005 will be represented
by our third fiscal quarter revenues. In anticipation of increased sales
activity during the third fiscal quarter, we incur significant additional
expenses, including significantly higher inventory and staffing costs. If sales
for the third fiscal quarter do not meet anticipated levels, then increased
expenses may not be offset, which would adversely affect our financial
condition. If we were to experience lower than expected sales during one of our
third fiscal quarters, for whatever reason, it would have a disproportionately
large negative impact on our annual operating results and financial condition
for that fiscal year. If our net revenues during our third fiscal quarter were
to fall below the expectations of securities analysts, our stock price could
decline, perhaps significantly. Our operating results are volatile and difficult to predict and may adversely affect our stock price. Our annual and quarterly operating results have fluctuated in the past and
may fluctuate significantly in the future due to a variety of factors, many of
which are outside of our control. Further, because our business is seasonal,
our operating results may vary significantly from one quarter to the next as
part of our normal business cycle. As a result, we believe that quarterly
comparisons of our operating results are not necessarily meaningful and that
you should not rely on the results of one quarter as an indication of our
future performance. It is likely that in some future quarter our operating
results may fall below the expectations of securities analysts and investors.
In this event, the trading price of our common stock could decline
significantly. Factors that could cause our operating results to fluctuate include the
following:  
    
    The seasonality of our business
    
    Decreases in the number of visitors to our website or our inability to convert those visitors into customers
    
    Technical difficulties, including system or Internet failures
    
    Fluctuations in the demand for our products
    
    The number of prior customers that make repeat purchases
    
    Overstocking or understocking of our merchandise
    
    Offering of new or enhanced services or more popular products by our competitors
    
    Fluctuations in the level of our product returns
    
    Termination of existing marketing relationships or failure to develop successful new marketing relationships
    
    Fluctuations in shipping costs, particularly during the holiday season 16




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
    
    Fluctuations in advertising, marketing or catalog production and distribution costs
    
    Fluctuations in personalization and fulfillment costs
    
    The amount and timing of operating costs and capital expenditures relating to expansion or upgrade of our
operations
    
    Changes in government regulations and taxation related to use of the Internet or otherwise applicable to
our business
    
    Economic conditions generally or economic conditions specific to the Internet, online commerce, the retail
industry, the mail order industry or the gift industry
    
    Changes in the mix of products that we sell
    
    Fluctuations in levels of inventory theft, damage or obsolescence Our computer and communications hardware and software systems are vulnerable to damage and interruption, which could harm
our business. Our ability to receive and fulfill orders successfully through our website is
critical to our success and largely depends upon the efficient and
uninterrupted operation of our computer and communications hardware and
software systems. Our systems and operations are vulnerable to damage or
interruption from power outages, computer and telecommunications failures,
computer viruses, security breaches, catastrophic events (such as natural
disasters or terrorist attacks), and errors in usage by our employees and
customers. Further, our servers are located at the facilities of, and hosted
by, a third-party service provider in Santa Clara, California. In the event
that this service provider experiences any interruption in its operations or
ceases operations for any reason or if we are unable to agree on satisfactory
terms for a continued hosting relationship, we would be forced to enter into a
relationship with another service provider or take over hosting
responsibilities ourselves. We cannot assure you that, in the event it became
necessary to switch hosting facilities, we would be successful in finding an
alternative service provider on acceptable terms or in hosting the computer
servers ourselves. Any significant interruption in the availability or
functionality of our website, or our sales processing, fulfillment or
communications systems for any reason, particularly an interruption during the
holiday season, could seriously harm our business. If we fail to offer a broad selection of innovative merchandise that consumers
find attractive, our revenues could decline or fail to reach anticipated levels
and our stock price could be harmed. In order to meet our strategic goals, we must successfully offer, on a
continuous basis, a broad selection of appealing products. These products must
satisfy the diverse tastes of our customers and potential customers for a
variety of gift-giving occasions. To be successful, our product offerings must
be affordable, well made, innovative and attractive to a wide range of
consumers whose preferences may change regularly. We cannot predict with
certainty that we will be successful in offering products that meet these
requirements. If our products become less popular with consumers, our revenues
may decline or fail to meet expected levels or we may decide to offer our
products at lower prices. If a wide range of consumers do not find our products
attractive or if we are required to reduce our prices, our revenues and
earnings may decline or fail to meet expected levels and our stock price could
be affected adversely. 17




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Failure to successfully manage or expand our fulfillment and distribution
operation would have a material adverse effect on us. Our fulfillment and distribution operation is located in leased facilities
in Lockbourne, Ohio. Our agreement with the fulfillment services company that
previously managed the fulfillment and distribution operations at the
Lockbourne, Ohio facility expired in August 2003, at which point we assumed
direct control of fulfillment and distribution operations. We have limited
experience managing fulfillment and distribution operations, and we cannot
assure you that we will be successful in this endeavor. We experienced
significant difficulties managing the fulfillment and distribution operations
during the 2003 holiday season, including difficulties in inventory management
and timely gift personalization, and anticipated efficiencies from managing the
distribution center ourselves did not materialize during that period. If we are
unable to manage successfully our fulfillment and distribution operations and
to meet our customers expectations regarding personalization, presentation and
delivery, our operations and financial condition could be seriously harmed. Any
difficulty in managing our fulfillment and distribution operations could
require us to find one or more parties to provide these services for us. If we
are required to engage one or more service providers, we could incur higher
fulfillment expenses than anticipated or incur additional costs for balancing
merchandise inventories among multiple distribution facilities. Further, we may
need to expand or upgrade our distribution operations in the future to
accommodate increases in customer orders, increased demand for personalized
products or changes in available technology. If we fail to successfully manage,
expand or make necessary upgrades to our fulfillment and distribution
operations in a timely and cost-effective manner, it would have a material
adverse effect on our business. If we do not manage our inventory levels successfully, our operating results will be affected adversely. We must maintain sufficient inventory levels to operate our business
successfully. Rapidly changing trends in consumer tastes for gift items expose
us to significant inventory risks, particularly during our third fiscal quarter
when inventory levels are highest due to the holiday shopping season. Consumer
preferences can change between the time we order a product and the time it is
available for sale. We base our product selection on our projections of
consumer tastes and preferences in a future period, and we cannot guarantee
that our projections of consumer tastes and preferences will be accurate. It is
critical to our success that we accurately predict consumer tastes and stock
our product offerings in appropriate quantities. In the event that one or more
products do not achieve widespread consumer acceptance, we may be required to
take significant inventory markdowns, which could reduce our net sales and
gross margins. This risk may be greatest in the third fiscal quarter of each
year, after we have significantly increased inventory levels for the holiday
shopping season. In addition, to the extent that demand for our products
increases over time, we may be forced to increase inventory levels. Any such
increase would require the use of additional working capital and subject us to
additional inventory risks. Further, our failure to stock sufficient quantities
of popular products would likely cause us to miss revenue opportunities and
could cause our customers to become dissatisfied and look to our competitors
for their gift items. During the 2003 holiday season, some of our popular items
were not stocked in quantities sufficient to meet the demand for such items,
which likely led to missed sales opportunities. If we fail to stock popular
products in sufficient quantities or if we overstock products, our business,
financial condition and operating results would be affected adversely. We may have difficulty in product sourcing. More than half of our products are unique designs manufactured by
third-party suppliers. We enter into exclusive supply agreements for these
products to maintain a competitive advantage. However, since we do not have
long-term arrangements with any vendor or distributor that would guarantee the
availability of products from year to year, we do not have a predictable or
guaranteed supply of these products in the future. If we are unable to provide
our customers with continued access to popular, exclusive products, our
operating results could be harmed. In addition, we may receive products from our suppliers that do not meet
our quality standards. From time to time, we receive products from suppliers
that are of insufficient quality to provide to our customers. Generally the
supplier is able to quickly rectify the problem, but occasionally we have been
unable to obtain replacement product quickly enough to fulfill all customer
orders for such product in a timely manner, particularly with respect to items
sourced overseas which tend to have longer delivery lead time requirements. If
we receive products from our suppliers that do not meet our high quality
standards and we are unable to obtain suitable replacement products in a timely
manner, our reputation and our operating results could be harmed. Further,
customers who do not receive their products in a timely manner may look to our
competitors for their gift items. 18




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Many of our products are sourced overseas. While products sourced overseas
typically have lower costs, our product margins may be slightly offset by an
increase in inbound freight costs. As security measures around shipping ports
increase, these additional costs may result in higher inbound freight costs.
Furthermore, in recent years, U.S. companies were subject to port strikes which
delayed the delivery of goods. As we increase our overseas sourcing, we face
the risk of these delays which could harm our business and results of
operations. We cannot predict whether any of the countries in which our
merchandise currently is manufactured or may be manufactured in the future will
be subject to additional trade restrictions imposed by the U.S. and other
foreign governments, including the likelihood, type or effect of any such
restrictions. Trade restrictions, including increased tariffs or quotas,
embargoes, and customs restrictions, against items that we offer or intend to
offer to our customers, as well as U.S. or foreign labor strikes, work
stoppages or boycotts, could increase the cost or reduce the supply of items
available to us and adversely affect our business, financial condition and
results of operations. Our sourcing operations also may be adversely affected
by political and financial instability resulting in the disruption of trade
from exporting countries, significant fluctuation in the value of the U.S.
dollar against foreign currencies, restrictions on the transfer of funds and/or
other trade disruptions. Any disruption or delays in, or increased costs of,
importing our products could have an adverse effect on our business, financial
condition and operating results. Our facilities and systems are vulnerable to natural disasters or other catastrophic events. Our headquarters, customer service center and the majority of our
infrastructure, including computer servers, are located in California, an area
that is susceptible to earthquakes and other natural disasters. Our
distribution facility, located in Lockbourne, Ohio, houses substantially all of
our product inventory and is the location from which substantially all of our
sales are shipped. A natural disaster or other catastrophic event, such as an
earthquake, fire, flood, severe storm, break-in, terrorist attack or other
comparable problems could cause interruptions or delays in our business and
loss of data or render us unable to accept and fulfill customer orders in a
timely manner, or at all. Further, California has in the recent past
experienced power outages as a result of limited electrical power supplies.
These outages may recur in the future and we cannot determine the effect, if
any, that such outages would have on the operation of our business. In
addition, as our inventory and distribution facility is located in an area that
is susceptible to harsh weather, a major storm, heavy snowfall or other similar
event could prevent us from delivering products in a timely manner. Also, areas
in and around San Diego, California, the site of our customer service facility,
have experienced severe wildfires. Such wildfires could destroy, render
inoperable or cause the evacuation of our customer service facility, which
could significantly disrupt our ability to provide satisfactory customer
service. We have no formal disaster recovery plan and our business interruption
insurance may not adequately compensate us for losses that may occur from any
of the foregoing. In the event that an earthquake, natural disaster or other
catastrophic event were to destroy any part of our facilities or interrupt our
operations for any extended period of time, or if harsh weather conditions
prevent us from delivering products in a timely manner, our business, financial
condition and operating results would be seriously harmed. We have grown quickly and if we fail to manage our growth, our business will suffer. We have rapidly and significantly expanded our operations, and anticipate
that further significant expansion, including the possible acquisition of
third-party assets, technologies or businesses, will be required to address
market opportunities and desired growth in our customer base. Prior expansion
has placed, and any future expansion is expected to continue to place, a
significant strain on our management, operational and financial resources. Some
of our officers or senior management personnel have no prior senior management
experience at public companies. Our new employees include key officers as well
as a number of key managerial, technical and operations personnel who have not
yet been fully integrated into our operations. Additionally, we need to
properly implement and maintain our financial and managerial controls,
reporting systems and procedures, including the increased internal controls and
procedures required by the recently enacted Sarbanes Oxley Act of 2002.
Moreover, if we are presented with appropriate opportunities, we may in the
future make investments in, or possibly acquire, assets, technologies or
businesses that we believe are complementary to ours. Any such investment or
acquisition may further strain our financial and managerial controls and
reporting systems and procedures. These difficulties could disrupt our
business, distract our management and employees or increase our costs. If we
are unable to manage growth effectively, implement proper controls and systems
in an efficient manner, or successfully integrate any assets, technologies or
businesses that we may acquire, our business, financial condition and results
of operations would be affected adversely. 19




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We experience intense competition in the rapidly-changing retail gift market. We operate in a highly competitive environment. We principally compete
with a variety of department stores, Internet retailers, specialty retailers
and other catalog merchandisers that offer products similar to or the same as
our products. Increased competition is likely to result in price reductions,
reduced gross margins and loss of market share, any of which could seriously
harm our net revenues and results of operations. We expect competition to
intensify in the future because current and new competitors can enter our
market with little difficulty and can launch new websites at a relatively low
cost. We currently or potentially compete with a variety of other companies,
including:  
    
    other online retailers, such as Amazon.com
    
    major department stores, such as Macys, Bloomingdales and Neiman Marcus
    
    physical and online stores and catalog retailers that sell popular gift items such as Williams-Sonoma,
Brookstone, The Sharper Image, Tiffanys, Harry & David, J Crew, and 1-800-Flowers
    
    Internet portals and online service providers that feature shopping services, such as AOL, Yahoo! and Lycos Many of our traditional store-based, catalog-based and online competitors
have longer operating histories, larger customer or user bases, greater brand
recognition and significantly greater resources, particularly financial and
marketing resources. Many of these competitors can devote substantially more
resources to website development and catalog retailing than we can. In
addition, large, well-established and well-financed entities may establish more
robust online sales operations in the future. Our competitors may be able to
secure products from vendors on more favorable terms, provide popular products
to which we do not have access, fulfill customer orders more efficiently and
adopt more aggressive pricing or inventory availability policies than we can. The U.S. retail industry, the specialty retail industry in particular, and
the online commerce sector are highly competitive, dynamic in nature and have
undergone significant changes over the past several years and will likely
continue to undergo significant changes. Our ability to anticipate and respond
successfully to these changes is critical to our long-term growth and we cannot
assure you that we will anticipate and respond successfully to changes in the
retail industry and online commerce sectors. If we are unable to maintain or
increase our market share or compete effectively in the retail gift market, our
business, financial condition and operating results would be adversely
affected. If we do not successfully expand our website and order processing systems or
respond to rapid technological changes, we could lose customers and our net
revenues could decline. If we fail to upgrade our website in a timely manner to accommodate higher
volumes of traffic, our website performance could suffer and we may lose
customers. In addition, if we fail to expand the computer systems that we use
to process and ship customer orders and process customer payments, we may not
be able to fulfill customer orders successfully. As a result, we could lose
customers and our net revenues could be reduced. Further, to remain
competitive, we must continue to enhance and improve the functionality and
features of our online store. The Internet and the online commerce industry are
subject to rapid technological change. If competitors introduce new features
and website enhancements, or if new industry standards and practices emerge,
our existing website and systems may become obsolete or unattractive.
Developing our website and other systems entails significant technical and
business risks. We may use new technologies ineffectively or we may fail to
adapt our website, our transaction processing systems and our computer network
to meet customer requirements or emerging industry standards. If we are
unsuccessful in upgrading our systems to accommodate higher traffic or
developing or implementing new technologies that enable us to meet evolving
industry standards and remain competitive, our operating results would be
seriously harmed. 20




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We are currently in the process of implementing certain system
enhancements and upgrades, including a new warehouse management system, an
order-entry system, an updated financial software package and software to enhance the features
of our website. Also, we are in
the process of modifying certain internal processes for the purpose of
improving our productivity and making our operations more cost efficient.
However, we cannot assure you that we will be successful in these efforts.
Possible cost overruns in these implementation efforts may result in higher
than anticipated capital expenditures and delays in or other problems arising out of these
implementations could lead to customer dissatisfaction. If we do not successfully implement one
or more of these intended upgrades or modified processes or if we do not
achieve desired efficiencies or cost savings as a result of these changes or if attempts to enhance
our website are unsuccessful or are not appealing to our customers, our
business and operating results could be harmed, perhaps significantly. Delivery of our merchandise could be delayed or disrupted by factors beyond our
control, and we could lose customers as a result. As timely gift delivery is essential to our customers satisfaction, any
delay or disruption in order, fulfillment and shipping, particularly during the
holiday shopping season, could cause us to lose customers and negatively affect
our business. In addition, we rely upon third-party carriers for timely
delivery of our product shipments. As a result, we are subject to carrier
disruptions and increased costs due to factors that are beyond our control,
including employee strikes, inclement weather and increased fuel costs. Any
failure to deliver products to our customers in a timely and accurate manner
would damage our reputation and brand and could cause us to lose customers. We also depend on temporary employees to adequately staff our distribution
facility during busy periods such as the holiday shopping season, including
individuals responsible for gift personalization and packaging. We cannot
assure you that we will continue to receive adequate assistance from our
temporary employees, or that we will continue to have access to sufficient
numbers of competent temporary employees on a cost-effective basis,
particularly during the holiday shopping season, which season is critical to
our business. If we are unable to adequately staff our distribution and
fulfillment facility during the holiday shopping season and other periods of
increased activity, our operations and sales during such period could suffer,
and our reputation could be harmed. Increased merchandise returns and a failure to accurately predict merchandise
returns could harm our business. As part of our customer service commitment, we maintain a merchandise
return policy that allows recipients to return most non-personalized
merchandise items received from us if they are dissatisfied with those items.
We make allowances for merchandise returns in our financial statements based on
historical return rates. We cannot assure you that actual merchandise returns
will not significantly exceed our allowances for returns. In addition, because
our allowances are based on historical return rates, we cannot assure you that
the introduction of new merchandise in our catalogs, the introduction of new
catalogs, increased sales over the Internet, changes in our merchandise mix,
changes in the habits of our gift item recipients, or other factors will not
cause actual returns to exceed return allowances, perhaps significantly. Any
increase in merchandise returns that exceed our allowances would affect our
business adversely. Also, returned merchandise that is personalized,
perishable, or damaged likely cannot be re-sold, creating non-recoverable
inventory costs which detrimentally affects our operating results. If we are unable to successfully manage the costs of our catalog operations or
our catalogs fail to produce sales at satisfactory levels it could adversely
affect our business. Our catalog has been an important tool for the acquisition and retention
of customers. We believe that the success of our catalog as a cost-effective
marketing tool depends on the following factors:  
    
    effective management of costs associated with the production and distribution of our catalog
    
    achievement of adequate response rates to our mailings
    
    displaying a mix of merchandise in our catalog that is attractive to our customers
    
    cost-effective production of appealing catalogs
    
    timely delivery of catalog mailings to our customers 21




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Catalog production and mailings entail substantial paper, printing,
postage and human labor costs. Increases in the costs of producing and
distributing the RedEnvelope catalog, including increases in postage rates or
paper, photography, or printing costs, may reduce the margin on sales derived
from our catalog. The U.S. Postal Service is likely to increase its postage
rates in the future and other delivery and overnight courier services that we
utilize to deliver our products also will likely raise their rates in the
future, which could significantly increase the aggregate cost of mailing our
catalogs. As we incur nearly all of the costs associated with our catalogs
prior to mailing, we are unable to adjust the costs being incurred in
connection with a particular mailing to reflect the actual performance of the
catalog. In addition, response rates to our mailings and, as a result, revenues
generated by each mailing, are affected by factors such as constantly changing
consumer preferences and our ability to include a product assortment that
satisfies those preferences, economic conditions, the timing and mix of catalog
mailings, the timely delivery by the postal system of our catalog mailings, and
changes in our merchandise mix, several or all of which may be outside of our
control. If we were to experience an increase in the costs associated with
producing or distributing our catalogs or our catalogs fail to produce sales at
satisfactory levels, our operating results would be adversely affected. We are dependent on the success of our advertising and marketing efforts which
are costly and may not achieve desired results. Our revenues depend on our ability to advertise and market our products
effectively through the RedEnvelope catalog and our other advertising and
marketing efforts. If we do not successfully advertise and market our products,
our operating results will be seriously harmed. Increases in the cost of
advertising and marketing, including paper and postage costs and the costs of
complying with applicable regulations, may limit our ability to advertise and
market our business without reducing our profitability. In addition,
individuals are increasingly using software programs that block certain email
marketing campaigns, and certain Federal and state laws and regulations may
restrict our ability to effectively utilize email as a marketing tool. We are currently in the process
of modifying our mix of advertising to include more print and outdoor advertising. If we
decrease our advertising or marketing activities, if the effectiveness of such
activities is diminished, due to increased costs, restrictions enacted by
regulatory agencies or for any other reason or if our current advertising strategy does not yield anticipated results, our future operating results could
be significantly harmed. We expect to increase spending on advertising and
marketing in the future, and if such efforts do not produce a sufficient level
of sales to cover their costs, it would harm our operating results. Recent changes to our shipping rate policy could cause our revenues to decline. In August 2003, we changed our shipping rate policy from a graduated rate
schedule, based on the cost of the item(s) purchased by a customer, to a
consistent flat rate per shipment. This change will have the effect of lowering
our average per-shipment shipping fee, thereby reducing our shipping revenues
per order. While we believe that this change to our shipping rate policy will
be conducive to an increase in our order volume, we cannot assure you that our
order volume will be increased or that any increase in shipments will offset
the reduction in per-shipment shipping revenues resulting from our shipping
rate policy change. We believe that this change in shipping rate policy had an
aggregate negative impact on our revenues for the third fiscal quarter of 2004,
which was the first full quarter following the policy change, and it is
possible that the policy change could have a negative impact on our revenues in
future periods. If our aggregate shipping revenues decrease as a result of the
change in our shipping rate policy without a commensurate rise in product
revenue, our business, financial condition and results of operations could be
harmed. If we are unable to provide satisfactory customer service, we could lose customers. Our ability to provide satisfactory levels of customer service depends, to
a large degree, on the efficient and uninterrupted operation of our call
center. Any material disruption or slowdown in our order processing systems
resulting from labor disputes, telephone or Internet failures, power or service
outages, natural disasters or other events could make it difficult or
impossible to provide adequate customer service and support. Further, we may be
unable to attract and retain adequate numbers of competent customer service
representatives, which is essential in 22




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creating a favorable interactive customer experience. Due to increased
customer service needs during the holiday shopping season, we hire a relatively
large number of temporary employees during our third fiscal quarter. As a
result, we may have difficulty properly staffing our customer service
operations during our peak sales season. Further, temporary employees may not
have the same levels of training or professional responsibility as full-time
employees and, as a result, may be more likely to provide unsatisfactory
service to our customers and potential customers. If we are unable to
continually provide adequate staffing for our customer service operations, our
reputation could be seriously harmed. In addition, we cannot assure you that
email and telephone call volumes will not exceed our present system capacities.
If this occurs, we could experience delays in placing orders, responding to
customer inquiries and addressing customer concerns. Our customer service
facility currently accommodates customer service representatives at close to
its capacity during our peak sales period. We currently plan on hiring
additional customer service representatives in our distribution center in Ohio
to accommodate the overflow of calls. Because our success depends in large part
on keeping our customers satisfied, any failure to provide high levels of
customer service or adequately staff our customer service operations would
likely impair our reputation and have an adverse effect on our business and
operating results. The loss of our senior management or other key personnel could harm our current
and future operations and prospects. Our performance is substantially dependent on the continued services and
on the performance of our senior management and other key personnel,
particularly Alison L. May, our President and Chief Executive Officer. One of
our long-time officers and directors, Hilary Billings, recently resigned from
RedEnvelope. While we believe that this will have no material impact on our
operations, we cannot assure you that disruptions occasioned by her departure
will not have an adverse impact on our near-term operations. Our performance
also depends on our ability to retain and motivate other officers and key
employees. We do not have long-term employment agreements with any of our key
personnel. The loss of the services of Ms. May or any of our executive officers
or other key employees for any reason could harm our business, financial
condition and operating results. Our future success also depends on our ability
to identify, attract, hire, train, retain and motivate other highly-skilled
technical, managerial, editorial, merchandising, marketing and customer service
personnel. Competition for such personnel is intense, particularly in the San
Francisco Bay Area, and we cannot assure you that we will be able to
successfully attract, assimilate or retain sufficiently qualified personnel.
Our failure to attract and retain the necessary technical, managerial,
editorial, merchandising, marketing and customer service personnel would harm
our business, financial condition and results of operations. Our current proxy contest will divert management and financial
resources and could result in a substantial change in company management. Four of our stockholders have commenced a proxy
contest seeking to have an opposing slate of directors elected to our Board at our upcoming stockholder meeting.
This proxy contest is likely to be extremely costly and will require the attention of our senior management team, preventing
them from focusing their full attention on our operations. Any diversion of our senior management personnel could have
a detrimental effect on our operations. We currently anticipate that we will incur up to $250,000 in
additional costs as a result of this proxy contest, which amount could increase significantly in the event
that any litigation ensues. In addition, these stockholders may seek to have their proxy contest expenses,
approximated at up to an additional $275,000, reimbursed by the Company, particularly if they are successful in their efforts.
In the event that these stockholders are successful in having their opposing slate of directors elected, then the
entire current Board of Directors, with the exception of Scott Galloway, would be replaced. Additionally, these
stockholders have indicated that if they are successful in having their opposing slate of directors elected
they will immediately replace the Companys Chief Executive Officer. Such a wholesale change in leadership, particularly
in advance of the Companys holiday sales season, would likely
be disruptive to the Companys operations and could have a
material adverse effect on the Companys business and results of operations. If the protection of our trademarks and proprietary rights is inadequate, our
brand and reputation could be impaired and we could lose customers. We regard our copyrights, service marks, trademarks, trade dress, trade
secrets and similar intellectual property as critical to our success. We rely
on trademark and copyright law, trade secret protection and confidentiality
agreements with our employees, consultants, partners, suppliers, and others to
protect our proprietary rights. Nevertheless, the steps we take to protect our
proprietary rights may be inadequate. Further, effective trademark, service
mark, copyright and trade secret protection may not be available in every
country in which we will sell our products and offer our services. Currently,
we are involved in a trademark dispute with a company based in the United
Kingdom regarding trademark rights in the United Kingdom and European
Community. For more information on this dispute, see Part I. Item 3  Legal
Proceedings below. In addition, the relationship between regulations governing
domain names and laws protecting trademarks and similar proprietary rights is
unclear. Therefore, we may be unable to prevent third parties from acquiring
domain names that are similar to, infringe upon or otherwise decrease the value
of our trademarks and other proprietary rights. If we are unable to protect or
preserve the value of our trademarks, copyrights, trade secrets or other
proprietary rights for any reason, our business would be harmed. We also rely substantially on technologies that we license from third
parties. These licenses may not continue to be available to us on commercially
reasonable terms, or at all, in the future. As a result, we may be required to
develop or obtain substitute technology of lower quality or at greater cost, or
we may be prevented from providing features or functionality on our website
that our customers and potential customers desire, any of which could
materially adversely affect our business, operating results and financial
condition. 23




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Intellectual property claims against us could be costly and could impair our business. Other parties may assert infringement or unfair competition claims against
us. In the past, we have received notices from third parties alleging that our
trademarks or product offerings infringe proprietary rights held by them. We
have also in the past received claims and have been a defendant in a lawsuit
alleging that our Internet marketing program and website operations infringe
patents held by third parties. For additional information on this lawsuit, see
Part II Item 1   Legal Proceedings below. We may receive other similar notices
from, or have lawsuits filed against us by, third parties in the future. We
cannot predict whether third parties will assert claims of infringement against
us, or whether any past, present or future claims will prevent us from offering
popular products or operating our business as planned. If we are forced to
defend against thirty-party infringement claims, whether they are with or
without merit or are determined in our favor, we could face expensive and
time-consuming litigation, which could distract technical and management
personnel, or result in product shipment delays. If an infringement claim is
determined against us, we may be required to pay monetary damages or ongoing
royalties. Further, as a result of infringement claims either against us or
against those who license technology to us, we may be required to develop
non-infringing intellectual property or enter into costly royalty or licensing
agreements. Such royalty or licensing agreements, if required, may be
unavailable on terms that are acceptable to us, or at all. If a third-party
successfully asserts an infringement claim against us and we are required to
pay monetary damages or royalties or we are unable to develop suitable
non-infringing alternatives or license the infringed or similar intellectual
property on reasonable terms on a timely basis, it could significantly harm our
business. We face the risk of inventory shrinkage. We are subject to the risk of inventory loss and theft, particularly with
respect to our growing line of jewelry products. Although we believe that the
levels of inventory shrinkage that we have suffered in the past are within an
acceptable range, we cannot assure you that incidences of inventory loss and
theft will not increase in the future or that the security measures we have
taken in the past will effectively address the problem of inventory theft. If
we were to suffer higher rates of inventory shrinkage or incur increased
security costs to combat inventory theft, our financial condition could be
affected adversely. Poor economic conditions may constrain discretionary consumer spending on retail products such as ours. Consumer spending patterns, particularly discretionary spending for
products such as ours, are affected by, among other things, prevailing economic
conditions, stock market volatility, wars, threats of war, acts of terrorism,
wage rates, interest rates, inflation, taxation, and consumer confidence.
General economic, political and market conditions, such as recessions, may
adversely affect our business results and the market price of our common stock.
The terrorist attacks of September 11, 2001 and the wars in Afghanistan and
Iraq had a negative effect on an already slowing economy and on consumer
confidence. Our business and revenues have been, and could continue to be,
negatively affected by poor economic conditions and any related decline in
consumer demand for discretionary items such as our products. We face
uncertainty in the degree to which poor performance in the retail industry,
decreased consumer confidence or any economic slowdown will negatively affect
demand for our products. We may not be able to accurately anticipate the
magnitude of these effects on future quarterly results, which could seriously
harm our financial condition. As we do not have large cash reserves, we may not
be able to survive an extended recession or sluggish economy. We may need additional financing and may not be able to raise additional
financing on favorable terms or at all, which could increase our costs, limit
our ability to grow and dilute the ownership interests of existing
stockholders. We anticipate that we may need to raise additional capital in the future
to facilitate long-term expansion, to respond to competitive pressures or to
respond to unanticipated financial requirements. Since our inception, we have
experienced negative cash flow from operations on a fiscal year basis and may
experience negative cash flow from operations on a fiscal year basis for the
foreseeable future. We cannot be certain that we will be able to obtain additional financing on commercially reasonable terms or at all. 24




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If we
raise additional funds through the issuance of equity, equity-related or debt
securities, such securities may have rights, preferences or privileges senior
to those of the rights of our common stock and our stockholders will experience
dilution of their ownership interests. Further, under the terms of our credit
agreement with CapitalSource Finance LLC, we are subject to certain contractual
limitations with respect to raising additional capital during the term of that
agreement. A failure to obtain additional financing or an inability to obtain
financing on acceptable terms could require us to incur indebtedness that has
high rates of interest or substantial restrictive covenants, issue equity
securities that will dilute the ownership interests of existing stockholders,
or scale back, or fail to address opportunities for expansion or enhancement
of, our operations. If we default on any secured loan, all or a portion of our assets could be subject to forfeiture. We are currently party to a credit agreement that is secured by
substantially all of our tangible and intangible assets, and we may enter into
secured credit or loan agreements in the future. If we default on our current
or any future secured loan for any reason and are unable to cure the default
pursuant to the terms of the relevant agreement, our lenders could take
possession of any or all assets in which they hold a security interest,
including intellectual property, and dispose of those assets to the extent
necessary to pay off our debts, which could materially harm our business. We may face product liability claims that are costly and create adverse publicity. If any of the products that we sell causes harm or financial damages to
any of our customers or other individuals, we could be vulnerable to product
liability lawsuits. If we are found liable under product liability claims, we
could be required to pay substantial monetary damages and our reputation could
suffer. Further, even if we successfully defend ourselves against this type of
claim, we could be forced to spend a substantial amount of money in litigation
expenses, our management could be required to spend valuable time in the
defense against these claims and the claims could bring adverse publicity to
us, any of which could harm our business. We may face difficulty expanding into international markets. We may expand our operations to sell our products internationally, but we
have relatively little experience in purchasing, marketing and distributing
products or services for international markets. It will be costly to establish
international facilities and operations, promote our brand internationally, and
develop localized websites, catalogs and other systems. Governments in other
countries may regulate Internet or other online services in such areas as
content, privacy, network security, encryption or distribution, which could
significantly affect our ability to conduct business in those countries. If we
are unsuccessful in our attempts to expand our operations into other countries,
our operating results could be harmed. We may incur significant costs or experience delays in product availability due
to regulations applicable to the sale of food products and live plants, which
may hurt our business. We currently offer select food items and live plants for sale to our
customers. Applicable federal, state or local regulations may cause us to incur
substantial compliance costs or delay the availability of those products. In
addition, any inquiry or investigation from a regulatory authority could have a
negative impact on our reputation. The occurrence of any of these events could
adversely affect our financial condition. If we fail to comply with the laws regulating the sale of tobacco products it
may have a negative impact on our reputation and make us vulnerable to
liability claims. We are required to verify the age of purchasers of our tobacco products.
If we fail to request or are unable to properly identify the age of our
purchasers, we could face substantial penalties and legal liability for sales
of tobacco products to underage persons. 25




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Any inquiry or investigation from a
regulatory authority could have a negative impact on our reputation and any
liability claims could subject us to fines, mandatory damages or require us to
spend significant time and money in litigation, any of which could adversely
affect our business, financial condition and operating results. Our charter documents, Delaware law and third-party contractual restrictions
may make an acquisition of us more difficult, even if an acquisition would be
beneficial to our stockholders. We are a Delaware corporation and the Delaware General Corporation Law
contains certain provisions that may make a change in control of our company or
the removal of incumbent directors more difficult. In addition, our Amended and
Restated Certificate of Incorporation and Bylaws, contain provisions that may
have the same effect, including the elimination of the ability of stockholders
to call special meetings or vote by written consent, the elimination of
cumulative voting for directors, and procedures requiring advance notification
for stockholder proposals. The elimination of cumulative voting substantially
reduces the ability of minority stockholders to obtain representation on the
Board of Directors. These provisions may discourage potential acquirers from
making a bid for our company, or make an acquisition of us or a tender offer to
our stockholders more difficult, even if such acquisition or tender offer would
be beneficial to our stockholders, and may reduce any premiums paid to
stockholders for their common stock. Additionally, under the terms of our credit agreement with CapitalSource
Finance LLC, we are subject to covenants that could restrict or place
limitations on our ability to be acquired by another company during the term of
the credit agreement, even if such acquisition would be beneficial to our
stockholders. Our success is tied in large part to the continued use of the Internet by a large number of consumers. Our future revenues and profits, if any, substantially depend upon the
continued widespread use of the Internet as an effective medium of commerce and
communication. Factors which could reduce the widespread use of the Internet
include:  
    
    actual or perceived lack of privacy protection
    
    actual or perceived lack of security of credit card information
    
    possible disruptions or other damage to the Internet or telecommunications infrastructure
    
    increased governmental regulation and taxation
    
    decreased use of personal computers Any decrease or less than anticipated growth in Internet usage could
significantly harm our business. Customers may be unwilling to purchase goods on the Internet. Approximately 72% of our products currently are purchased through our
website. Our long-term prospects therefore depend upon the general publics
increasing willingness to use the Internet as a means to purchase goods. The
failure of the Internet to continue to develop into an effective and reliable
tool for consumer purchases would seriously damage our future operations.
Online commerce is a relatively new concept, and online purchases may decline
or fail to increase as projected. The future of online commerce is highly
uncertain, many online commerce companies have ceased operations in recent
years and most existing online commerce companies have a relatively short
operating history. If consumers are unwilling to use the Internet to purchase
retail products, our business will be harmed. 26




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The security risks of online commerce, including credit card fraud, may
discourage customers from purchasing goods from us. In order for the online commerce market to develop successfully, we and
other market participants must be able to transmit confidential information,
including credit card information, securely over public networks. Third parties
may have the technology or know-how to breach the security of customer
transaction data. Any breach could cause consumers to lose confidence in the
security of our website and choose not to purchase from us. Although we take
the security of our systems very seriously, we cannot guarantee that our
security measures will effectively prohibit others from obtaining improper
access to our information and information of our customers. If a person is able
to circumvent our security measures, he or she could destroy or steal valuable
information or disrupt our operations. Any security breach could expose us to
risks of data loss, litigation and liability and could seriously disrupt our
operations and harm our reputation. We do not carry insurance against the risk of credit card fraud, so the
failure to prevent fraudulent credit card transactions could reduce our net
revenues and gross margin. We may suffer losses as a result of orders placed
with fraudulent credit card data even though the associated financial
institution approved payment of the orders. Under current credit card
practices, we may be liable for fraudulent credit card transactions because we
do not obtain a cardholders signature. If we are unable to detect or control
credit card fraud, our liability for these transactions could harm our
business, operating results or financial condition. If one or more states successfully assert that we should collect sales or other
taxes on the sale of merchandise purchased from our website, our business could
be harmed. We do not currently collect sales or other similar taxes for physical
shipments of goods into states other than California and Ohio. In the future,
one or more local, state or foreign jurisdictions may seek to impose sales tax
collection obligations on us. If sales tax obligations are successfully imposed
upon us by a state or other jurisdiction, we may suffer decreased sales into
such state or jurisdiction as the effective cost of purchasing goods from us
increases for those residing in such states or jurisdictions. We may also be
subject to value added and other taxes if we sell merchandise to customers
located in the European Union or elsewhere in the world and we may incur
significant financial and organizational burdens in order to set up the
infrastructure required to comply with applicable tax regulations. If
additional states or any other jurisdictions successfully assert that we should
collect sales or other taxes on the sale of our merchandise into these
jurisdictions our business and operating results could be affected adversely. Existing or future government regulation could harm our business. We are subject to the same federal, state and local laws as other
companies conducting business on the Internet, including consumer protection
laws, user privacy laws and regulations prohibiting unfair and deceptive trade
practices. In particular, under federal and state financial privacy laws and
regulations, we must provide notice to our customers of our policies on sharing
non-public information with third parties, must provide advance notice of any
changes to our privacy policies and, with limited exceptions, must give
consumers the right to prevent sharing of their non-public personal information
with unaffiliated third parties. Further, the growth of online commerce could
result in more stringent consumer protection laws that impose additional
compliance burdens on us. Today there are an increasing number of laws
specifically directed at the conduct of business on the Internet. Moreover, due
to the increasing use of the Internet, many additional laws and regulations
relating to the Internet are being debated at the state and federal levels.
These laws and regulations could cover issues such as freedom of expression,
pricing, consumer privacy, fraud, quality of products and services, taxation,
advertising, adult-oriented content, intellectual property rights and
information security. Applicability of existing laws to the Internet relating
to issues such as trademarks, copyrights and other intellectual property
issues, taxation, libel, obscenity and personal privacy could also harm our
business. For example, United States and international laws regulate our
ability to use customer information and to develop, buy and sell mailing lists.
The vast majority of these laws were adopted prior to the advent of the
Internet, and do not contemplate or address the unique issues raised by the
Internet. Those laws that do reference the Internet, such as the Digital
Millennium Copyright Act and the recent federal law regulating the commercial
use of e-mail (popularly known as CAN-SPAM), are only beginning to be
interpreted by the courts and their applicability and reach are therefore
uncertain. The restrictions imposed by, and costs of complying with, current
and possible future laws and regulations related to our business could harm our
business, operating results and financial condition. 27




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Tax authorities in a number of states, as well as a Congressional advisory
commission, are currently reviewing the appropriate tax treatment of companies
engaged in online commerce, and new state tax regulations may subject us to
additional state sales and income taxes, which could have an adverse effect on
our cash flows and results of operations. Further, there is a possibility that
we could be subject to significant fines or other payments for any past
failures to comply with these requirements. In its most recent session,
Congress refused to extend the U.S. Internet tax moratorium. Consequently,
states are free to impose new taxes on Internet access, which could slow the
growth of Internet use and of electronic commerce transactions over the
Internet. The State of California recently enacted a law that requires any company
that does business in California and possesses computerized data, in
unencrypted form, containing certain personal information about California
residents to provide prompt notice to such residents if that personal
information was, or is reasonably believed to have been, obtained by an
unauthorized person such as a computer hacker. The law defines personal
information as an individuals name together with one or more of that
individuals social security number, drivers license number, California
identification card number, credit card number, debit card number, or bank
account information, including any necessary passwords or access codes. As our
customers, including California residents, generally provide information to us
that is covered by this definition of personal information in connection with
their purchases via our website, our business will be affected by this new law.
As a result, we will need to ensure that all computerized data containing the
previously-described personal information is sufficiently encrypted or that we
have implemented appropriate measures to detect unauthorized access to our data
and to notify our California customers of any such access to the extent it
involves their personal information. Such measures will likely increase the
costs of doing business and, if we fail to detect and provide prompt notice of
unauthorized access as required by the new law, we could be subject to
potential claims for damages and other remedies available to California
residents whose information was improperly accessed or, under certain
circumstances, the State of California could seek to enjoin our business
operations until appropriate corrective actions have been taken. While we
intend to comply fully with this new law, we cannot assure you that we will be
successful in avoiding all potential liability or disruption of business
resulting from this law. If we were required to pay any significant amount of
money in satisfaction of claims under this new law, or any similar law enacted
by another jurisdiction, or if we were forced to cease our business operations
for any length of time as a result of our inability to comply fully with any
such law, our business, operating results and financial condition could be
adversely affected. Further, complying with the applicable notice requirements
in the event of a security breach could result in significant costs. Further, recently-enacted federal and state laws place restrictions on
email marketing that could make it more difficult for us to acquire new
customers, or to obtain repeat purchases from prior customers through
inexpensive electronic marketing methods. The CAN-SPAM Act, for example,
requires every commercial e-mail message to include an opt-out mechanism and
requires all senders to comply with their recipients opt out requests. It
also requires senders to label all commercial e-mail messages as advertisements
or solicitations. These requirements may reduce the effectiveness of our e-mail
marketing activities. If any current or future law requires us to eliminate or
curtail our email marketing efforts, our ability to obtain new customers and
increase revenues could be adversely affected or we could incur greater
marketing costs, either of which could harm our business. While we intend to
comply with applicable law regarding email marketing, there is no assurance
that we will not incur fines or other liability as a result of an inadvertent
violation of such a law. In addition, because our website is accessible over the Internet in
multiple states and other countries, we may be subject to their laws and
regulations or may be required to qualify to do business in those locations. We
are qualified to do business only in California and Ohio at present. Our
failure to qualify in a state or country where we are required to do so could
subject us to taxes and penalties and we could be subject to legal actions and
liability in those jurisdictions. The restrictions or penalties imposed by, and
costs of complying with, these laws and regulations could harm our business,
operating results and financial condition. Our ability to enforce contracts and
other obligations in states and countries in which we are not qualified to do
business could be hampered, which could have a material adverse effect on our
business. Further, an important aspect of the new Internet-focused laws is that
where federal legislation is absent, states have begun to enact
consumer-protective laws of their own and these can vary significantly from
state to state. Thus, it is difficult for any company to be sufficiently aware
of the requirements of all applicable state laws and it is also difficult or
impossible for any company to comply fully with the sometimes inconsistent
standards and requirements set by various states. In addition to the
consequences that could result from violating one or more state laws, the costs
of attempting to comply could be considerable. 28




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Laws or regulations relating to privacy and data protection may adversely
affect the growth of our Internet business or our marketing efforts. We are subject to increasing regulation relating to privacy and the use of
personal user information. For example, we are subject to various telemarketing
laws that regulate the manner in which we may solicit future suppliers and
customers. Such regulations, along with increased governmental or private
enforcement, may increase the cost of growing our business. California recently
enacted a law that will
require all commercial website operators that collect personal information
about California residents to adopt and post a privacy policy that meets
certain specified criteria. Any failure to comply with this new law could
subject us to civil penalties, injunctions, and/or lawsuits. In addition,
several states have proposed legislation that would limit the uses of personal
user information gathered online or require online services to establish
privacy policies. The Federal Trade Commission has adopted regulations
regarding the collection and use of personal identifying information obtained
from children under 13 years of age. Bills proposed in Congress would extend
online privacy protections to adults. Moreover, proposed legislation in the
United States and existing laws in other countries require companies to
establish procedures to notify users of privacy and security policies, obtain
consent from users for collection and use of personal information, and/or
provide users with the ability to access, correct and delete personal
information stored by companies. These data protection regulations and
enforcement efforts may restrict our ability to collect demographic and
personal information from users, which could be costly or harm our marketing
efforts. Further, any violation of privacy or data protection laws and
regulations may subject us to fines, penalties and damages and may otherwise
have a material adverse effect on our business, results of operations and
financial condition. We may be subject to liability for the Internet content that we publish. As a publisher of catalogs and online content, we face potential liability
for defamation, negligence, intellectual property infringement, or other claims
based on the information and other content contained in our catalogs and
website. In the past, parties have brought these types of claims and sometimes
successfully litigated them against online services. If we incur liability for
our catalog or online content, our financial condition could be affected
adversely and our reputation could suffer. Our directors, executive officers and significant stockholders hold a
substantial portion of our stock, which may lead to conflicts with other
stockholders over corporate transactions and other corporate matters. Our directors, executive officers and current beneficial holders of 5% or
more of our outstanding common stock own a significant portion of our stock.
These stockholders, acting together, are able to influence significantly all
matters requiring stockholder approval, including the election of directors and
significant corporate transactions such as mergers or other business
combinations. This control may delay, deter or prevent a third-party from
acquiring or merging with us. 
 Item 3.Quantitative and Qualitative Disclosures About Market Risk Interest Rate RiskWe currently maintain a portfolio of fixed and variable
rate investments consisting of cash equivalents and short-term marketable
securities, which can be affected by changes in market interest rates. The
objective of our investment activities is to preserve principal, while at the
same time maximizing yields without significantly increasing risk. To achieve
this objective, we invest in highly liquid, investment grade and government
debt securities. Our investments in debt securities are subject to interest
rate risk. According to our investment policy, we may invest in taxable and tax
exempt instruments. In addition, the policy establishes limits on credit
quality, maturity, issuer and type of instrument. Marketable securities are
classified as available for sale. Marketable securities are comprised of
government securities and corporate bonds. We do not use derivative financial
instruments in our investment portfolio. (See Note 3 of Notes to Financial
Statements) All highly liquid investments with maturity of three months or less at the
date of purchase are considered to be cash equivalents. The remaining
investments in marketable securities are considered short-term investments if
maturities range over three months but less than one year, or long
term investments if maturities are one year or longer. 29




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The following table lists our cash and cash equivalents, short-term
investments and long-term investments at June 27, 2004: June 27, 2004(In
thousands)Cash and cash equivalents
    
    $
    18,667Short-term investments
    
    
    10,495Total
    
    $
    29,162
 If interest rates changed adversely by 100 basis points, our results from
operations and cash flows would not be materially affected. Foreign Currency RiskWe purchase a significant amount of inventory from
vendors outside of the U.S. in transactions that are denominated in U.S.
dollars. As of June 27, 2004, any currency risks related to these transactions
were not significant to us. A decline in the relative value of the U.S. dollar
to other foreign currencies could, however, lead to increased purchasing costs. 
 Item 4.Controls and Procedures The Company evaluated the design and operation of its disclosure controls
and procedures to determine whether they are effective in ensuring that the
disclosure of required information is timely and made in accordance with the
Exchange Act and the rules and forms of the Securities and Exchange Commission.
This evaluation was made as of the end of the Companys most recent fiscal quarter under the supervision and with the participation of
management, including the Companys principal executive officer and principal
financial officer. Maintenance of
disclosure controls and procedures is an ongoing process and controls and
procedures may change over time. The Company also has established a Disclosure
Committee, which consists of certain members of the Companys senior
management. Based on this evaluation, our chief executive officer and our chief
financial officer have concluded that our disclosure controls and procedures,
as defined at Exchange Act Rules 13a-15(e) and 15d-15(e), are effective to
ensure that information required to be disclosed by the Company in reports that
it files under the Exchange Act is recorded, processed, summarized and reported
within the time periods specified in Securities and Exchange Commission rules
and forms. During the fiscal quarter, no changes were made to the
Companys internal controls over financial reporting that materially affected, or are reasonably
likely to affect, such internal controls over financial reporting. 30




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PART II.
OTHER INFORMATION




Item 1.Legal Proceedings

By its letter dated March 9, 2000, Red Letter Days Plc, a United Kingdom
company (Red Letter Days), asserted trademark rights in the United Kingdom in
the marks RED LETTER, RED LETTER DAYS and the image of a red envelope. Red
Letter Days offers experiential gifts in the United Kingdom. The letter claimed
that if we were to use our name and the REDENVELOPE service mark in the United
Kingdom in connection with retail sales of gifts, it would infringe Red Letter
Days trademark rights. We have made a number of attempts to reach an amicable
resolution of this dispute, but Red Letter Days has declined, to date, to enter
into settlement negotiations. Red Letter Days has opposed our applications to
register the REDENVELOPE and RedEnvelope stylized logo marks in the United
Kingdom and the European Community. Red Letter Days oppositions to our United
Kingdom and European Community trademark applications are pending. Evidentiary
submissions have been made by the parties in connection with those opposition
proceedings and a decision is not expected for several months. The sole issue
to be decided in the opposition proceedings is whether the REDENVELOPE mark is
entitled to registration in the stated jurisdictions.

Even if an opposition is
successful in preventing the subject trademark from being registered, that
decision by the registration authorities does not prevent the applicant from
using the mark in that jurisdiction. In order to prevent us from using the
RedEnvelope mark in the United Kingdom or European Community or to obtain any
other equitable relief or monetary relief, Red Letter Days would need to bring
a lawsuit against us in the appropriate jurisdiction. To the best of our
knowledge, no such lawsuit has been filed. We opposed Red Letter Days
application to register the RED LETTER mark in the United Kingdom, based on the
descriptiveness of the RED LETTER mark as applied to the services of Red Letter
Days. The United Kingdom trademark office has denied our opposition and has
approved the registration of the Red Letter Days mark in the United Kingdom.
This decision did not address a comparison of the REDENVELOPE and RED LETTER
marks. On September 3, 2003, Activ8now, LLC filed a patent infringement lawsuit
against the Company in the United States District Court, Northern District of
Georgia. The lawsuit alleged a cause of action for infringement of U.S. Patent
Nos. 6,535,889 and 6,557,006 based on the theory that certain of our website
operations were covered by such patents. On June 18, 2004, the Company and
Activ8now, LLC entered into a settlement agreement providing the Company with a
non-exclusive, irrevocable, paid-up, worldwide license to such patents in
exchange for a one-time fee and dismissal of the lawsuit with prejudice. The
settlement did not have a material adverse effect on the Companys financial
position or results of operations. From time to time, the Company is subject to legal proceedings and claims
in the ordinary course of business, including claims of alleged infringement of
trademarks and other intellectual property rights. The Company is not currently
aware of such legal proceedings or claims that it believes will have,
individually or in the aggregate, a material adverse effect on its financial
position or results of operations. 
 Item 2.Changes in Securities, Use of Proceeds and Issues or Purchases of Equity Securities On September 24, 2003, a Registration Statement on Form S-1 (Commission
File No. 333-106120) relating to our initial public offering was declared
effective by the Securities and Exchange Commission. The net proceeds to us
from the offering were approximately $29.0 million after deducting underwriting
discounts of $1.8 million. We used approximately $1.5 million of the net
proceeds for fees related to the offering (excluding banker fees). Since the
initial public offering, we have used approximately $4.1 million for purchases
of property and equipment. We also use the net proceeds to fund our working
capital requirements throughout the year. II-1




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Item 6.Exhibits and Reports on Form 8-K

(a) Exhibits

10.40
    
    Lease Agreement dated July 22, 2004 between 149 New Montgomery, LLC and RedEnvelope, Inc.31.1
    
    Certification of Chief Executive Officer required by Exchange Act Rules 13a-14(a) (Section 302)31.2
    
    Certification of Chief Financial Officer required by Exchange Act Rules 13a-14(a) (Section 302)32.1
    
    Certification required by 18 U.S.C.§1350, as adopted pursuant to §906 of the Sarbanes-Oxley
Act of 200232.2
    
    Certification required by 18 U.S.C.§1350, as adopted pursuant to §906 of the Sarbanes-Oxley
Act of 2002


(b) Reports on Form 8-K

Date:
    
    Item Reported On:April 12, 2004
    
    Item 12: The Company issued a press release announcing the
updated revenue outlook for the fiscal quarter ended March
28, 2004.May 11, 2004
    
    Item 12: The Company issued a press release of the
financial results for the fourth quarter and fiscal year
ended March 28, 2004.


II-2



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SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized. REDENVELOPE, INC.By:
    
    /s/ ERIC C. WONGEric C. WongChief Financial Officer
 Date: August 11, 2004 II-3




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EXHIBIT INDEX 10.40
    
    Lease Agreement dated July 22, 2004 between 149 New Montgomery, LLC and RedEnvelope, Inc.31.1
    
    Certification of Chief Executive Officer required by Exchange Act Rules 13a-14(a) (Section 302)31.2
    
    Certification of Chief Financial Officer required by Exchange Act Rules 13a-14(a) (Section 302)32.1
    
    Certification required by 18 U.S.C. § 1350, as adopted pursuant to § 906 of the Sarbanes-Oxley
Act of 200232.2
    
    Certification required by 18 U.S.C. § 1350, as adopted pursuant to § 906 of the Sarbanes-Oxley
Act of 2002