REDE Redenvelope (MM)

 

 

UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, DC 20549

Form 10-Q

(Mark One)

þ		QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended December 30, 2007

o		TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from                      to                     

Commission File Number: 0-50387

RedEnvelope, Inc.

(Exact Name of Registrant as Specified in Its Charter)

149 New Montgomery Street,
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 requirements for the past 90 days. Yes  þ      No  o

     Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

o  Large accelerated filer		o  Accelerated filer		þ  Non-accelerated filer		o  Smaller reporting company
		(Do not check if a smaller reporting company)

     Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act). Yes  o      No  þ

     The number of outstanding shares of the registrant’s common stock, $0.01 par value per share, was 9,527,811 as of February 6, 2008.

 

 

RedEnvelope, Inc.
REPORT ON FORM 10-Q
For the Quarter Ended December 30, 2007
TABLE OF CONTENTS

				Page
		PART I. FINANCIAL INFORMATION			3
Item 1.		Financial Statements (Unaudited)			3
		Condensed Balance Sheets as of December 30, 2007, April 1, 2007 and December 31, 2006			3
		Condensed Statements of Operations for the thirteen and thirty-nine weeks ended
		December 30, 2007 and December 31, 2006			4
		Condensed Statements of Cash Flows for the thirty-nine weeks ended December 30, 2007
		and December 31, 2006			5
		Notes to Condensed Financial Statements			6
Item 2.		Management’s Discussion and Analysis of Financial Condition and Results of Operations			9
Item 3.		Quantitative and Qualitative Disclosures About Market Risk			14
Item 4.		Controls and Procedures			14
		PART II. OTHER INFORMATION			15
Item 1.		Legal Proceedings			15
Item 1A.		Risk Factors			15
Item 2.		Unregistered Sales of Equity Securities and Use of Proceeds			25
Item 3.		Defaults Upon Senior Securities			25
Item 4.		Submission of Matters to a Vote of Security Holders			25
Item 5.		Other Information			25
Item 6.		Exhibits			25
EXHIBIT 31.1
EXHIBIT 31.2
EXHIBIT 32.1
EXHIBIT 32.2

PART I. FINANCIAL INFORMATION

See accompanying notes to these condensed financial statements.

See accompanying notes to these condensed financial statements.

RedEnvelope, Inc.
NOTES TO CONDENSED FINANCIAL STATEMENTS
(Unaudited)

1. Financial Statements — Basis of Presentation

     The condensed balance sheets of RedEnvelope, Inc. (referred to as the “Company”, “we”, “us”, and “our”) as of December 30, 2007 and December 31, 2006, the condensed statements of operations for the thirteen and thirty-nine week periods ended December 30, 2007 and December 31, 2006, and the condensed statements of cash flows for the thirty-nine week periods ended December 30, 2007 and December 31, 2006 have been prepared, without audit. In the Company’s 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 and thirty-nine week periods then ended. The balance sheet at April 1, 2007, presented herein, has been derived from the Company’s audited balance sheet included in the Company’s Annual Report on Form 10-K, for the fiscal year ended April 1, 2007.

     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 financial statements and notes thereto included in the Company’s Annual Report on Form 10-K, for the fiscal year ended April 1, 2007.

     The results of operations for the thirteen and thirty-nine weeks ended December 30, 2007 and December 31, 2006 are not 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.

     The Company’s fiscal year ends on the Sunday closest to March 31, resulting in a 52 or 53 week year. Fiscal 2007 ended on April 1, 2007 and was 52 weeks long. Fiscal 2008 will end on March 30, 2008 and will also be 52 weeks long. The Company reports its interim results on a fiscal quarter basis where 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. Certain Significant Accounting Policies

     The preparation of financial statements in accordance with accounting principles generally accepted in the United States of America requires management to make estimates and judgments that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities as of the date of the financial statements and reported amounts of revenues and expenses during the reporting period. Actual results could differ from these estimates and such differences could affect the results of operations reported in future periods. The Company’s significant accounting policies are set forth below.

      Net (Loss) Income Per Share — Basic net income (loss) per share is calculated by dividing net income (loss) by the weighted average shares of common stock outstanding during the period. Diluted net income (loss) per share is calculated by dividing net income (loss) by the weighted average shares of common stock outstanding and potential shares of common stock during the period. Potential shares of common stock include dilutive shares issuable upon the exercise of outstanding common stock options and unvested restricted stock. For loss periods, 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 anti-dilutive. The weighted average number of shares subject to stock options outstanding that were excluded from the calculation for both the thirteen and thirty-nine weeks ended December 30, 2007 because they were anti-dilutive were approximately 1.5 million.

     The following is a reconciliation of net income and the number of shares used in the basic and diluted earnings per share computations:

      Comprehensive Income (Loss) — Comprehensive income (loss) consists of two components, net income (loss) and other comprehensive income (loss). Other comprehensive income (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 income (loss). The Company’s only source of comprehensive income (loss) is net loss.

3. Results of Operations and Liquidity Matters

     The Company’s financial statements have been presented on the basis that it is a going concern, which contemplates the continuity of operations, realization of assets and the satisfaction of liabilities in the ordinary course of business. Based on the Company’s cash balance as of December 30, 2007, as well as projected cash flows from operations and projected cash available to the Company through its Revolving Credit Facility (defined in Note 7), the Company believes it has the ability to continue its operations through the first quarter of fiscal 2009 (the quarter ending June 29, 2008).

     In the thirty-nine weeks ended December 30, 2007, the Company incurred a net loss of $18.2 million, generated approximately $3.0 million of cash from operating activities. We had cash and cash equivalents of $12.3 million as of December 30, 2007 and $1.8 million as of January 27, 2008. Although the Company experienced an increase in the average unit retail price and the average revenue per order shipped was flat, the Company experienced a 31.3% decrease in new customer acquisitions and a 14.2% decrease in the number of orders shipped as compared to the same period in the prior year. The decline in orders shipped in the thirty-nine weeks ended December 30, 2007 resulted from a decline in customer response rates as compared to the same period in the prior year, as well as a reduction in marketing expenditures for new customer prospecting in the second half of fiscal 2007. Management expects these trends to continue in the near term.

     The Company has in place the Revolving Credit Facility, which is described more fully in Note 7. As of December 30, 2007, the borrowing base reflected an availability of $3.8 million and the Company had no borrowings under the Revolving Credit Facility. On June 29, 2007, the Company executed the Subordinated Promissory Note (defined and described more fully in Note 7) with a related party that provides for a term loan with availability of up to $2.6 million and expires on June 28, 2008. As of December 30, 2007, the Company had no borrowings under the Subordinated Promissory Note.

     The Company currently believes that the cash currently on hand and the cash available to it through its Revolving Credit Facility and the Subordinated Promissory Note will be sufficient to continue operations through the quarter ending June 29, 2008. The Company’s assessment is based on historical working capital needs, operating loss trends, and current business outlook. Beyond the quarter ending June 29, 2008, the Company will need to obtain equity and or additional debt financing to fund operations and capital expenditures. Management is aggressively reviewing options to obtain additional financing and has multiple discussions underway with a variety of potential partners. The Company intends to have a resolution for its need for additional capital resources in the next 90 days. However, there can be no assurance that when 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 stockholders. If adequate funds are not available when needed, the Company may be required to significantly modify the business model to reduce spending to a sustainable level. Such modification of the business model could also result in an impairment of assets which cannot be determined at this time.

4. Capitalized Software Write-off

     The Company began the process of implementing a new website platform for its internet-based commerce and marketing in the beginning of fiscal 2005. In the second quarter of fiscal 2008, the Company concluded that the project is not viable given that the platform was highly customized and without an upgrade path for the future. As a result of this decision, the Company recorded a non-cash charge in the second quarter of fiscal 2008 in the amount of $3.5 million to write-off the net book value of this platform, which was included in general and administrative expenses.

5. Stock-Based Compensation

     The Company’s results for the thirteen and thirty-nine weeks ended December 30, 2007 included $0.5 million and $1.5 million, respectively, of stock-based compensation for stock options. The Company’s results for the thirteen and thirty-nine weeks ended December 31, 2006 included $0.6 million and $1.7 million, respectively, of stock-based compensation for stock options and $0.1 million and $0.2 million, respectively, of stock-based compensation for restricted stock awards. Stock-based compensation costs for the thirteen and thirty-nine weeks ended December 30, 2007 and December 31, 2006 were included in general and administrative expenses.

     The fair value of each option award is estimated on the date of grant using the Black-Scholes valuation model and the assumptions noted in the table below. The expected term of options is based on observed historical exercise patterns. Groups of employees that have similar historical exercise patterns were considered separately for valuation purposes. The expected volatility of stock options is based upon historical volatility of the Company’s stock. The risk-free interest rate is based on the implied yield on a U.S. Treasury zero-coupon issue with a remaining term equal to the expected term of the option. The dividend yield reflects that the Company has not paid any cash dividends since inception and does not intend to pay any cash dividends in the foreseeable future.

     A summary of stock option activity for the thirty-nine weeks ended December 30, 2007 is presented as follows:

     The weighted average fair value of stock options granted during the thirteen weeks ended December 30, 2007 and December 31, 2006, was $2.05 and $1.71, respectively. The weighted average fair value of stock options granted during the thirty-nine weeks ended December 30, 2007 and December 31, 2006, was $2.29 and $4.10, respectively.

6. Income Taxes

     On April 2, 2007, the Company adopted the provisions of FASB Interpretation (FIN) No. 48, Accounting for Income Tax Uncertainties (FIN 48). FIN 48 prescribes a more-likely-than-not threshold for recognizing the benefits of tax return positions in the financial statements and provides guidance on derecognition, measurement, classification, interest and penalties, accounting in interim periods, disclosure and transition issues. There was no effect on the Company’s financial position, results of operations or cash flows as a result of adopting FIN 48. As of December 30, 2007, there was no accrued interest or penalties for unrecognized tax benefits. The total gross unrecognized tax benefits under FIN 48 was approximately $98,000.

     The Company does not expect to realize taxable net income for its full fiscal year ending March 30, 2008. The Company has not recorded a tax benefit in any period due to losses incurred and uncertainty of realizing the net operating loss carryforwards. Accordingly, no provision for income taxes has been made for the thirteen and thirty-nine week periods ended December 30, 2007.

7. Borrowing Arrangements

     On June 26, 2006, the Company executed a loan and security agreement with a lender that provides for a senior secured revolving credit facility in an amount equal to the lesser of $12.5 million or an amount determined under a borrowing base formula (the “Revolving Credit Facility”). The borrowing base formula is determined by the sum of the appraised net realizable liquidation value of eligible inventory, plus eligible credit card accounts receivable, less applicable reserves. As of December 30, 2007 and January 27, 2008, the borrowing base reflected an availability of $3.8 million and $2.3 million, respectively and the Company had no borrowings under the Revolving Credit Facility. Interest will accrue on amounts borrowed under the Revolving Credit Facility at the prime lending rate or a LIBOR rate plus an applicable margin. The terms of the Revolving Credit Facility provide for certain events of default and set forth affirmative and negative covenants, including without limitation certain financial covenants, to which the Company must adhere. The Revolving Credit Facility expires in June 2010. The Revolving Credit Facility also contains a covenant that prohibits the Company from paying cash dividends to its stockholders. Under the terms of the existing Revolving Credit Facility, we are subject to certain contractual limitations with respect to raising additional debt financing during the term of that agreement. Borrowings are secured by a first priority interest in all of the Company’s assets, tangible and intangible, and proceeds realized from the sale or other disposition thereof.

     On June 29, 2007, the Company executed a subordinated promissory note with The Integrity Brands Fund, L.P. (the “Subordinated Promissory Note”), a fund that is managed by the Company’s Chief Executive Officer and Chairman of the Board of Directors, who holds approximately 10% of the Company’s outstanding shares. The Subordinated Promissory Note provides for a term loan for up to a maximum principal amount of $2.6 million. All amounts borrowed under the Subordinated Promissory Note will bear interest at a per annum rate equal to the prime rate, which will increase by two percentage points in the event of a default (as defined therein). The Subordinated Promissory Note is subordinated and junior in right of payment to the prior payment in full of all the principal and unpaid accrued interest and all other obligations under the Revolving Credit Facility (referenced in the preceding paragraph). The Subordinated Promissory Note provides for certain events of default and expires on June 28, 2008. As of December 30, 2007, no amounts are outstanding under this Subordinated Promissory Note.

8. Legal Proceedings

     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 any 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.

9. Contingencies

     During the first quarter of fiscal 2008, the Company completed an evaluation of whether the Company, through its business activities, has established nexus in various jurisdictions with respect to sales and use taxes. If a company has nexus in a particular jurisdiction it is required to collect and remit sales and use tax for sales into such jurisdiction. As a result of this evaluation, the Company recorded an estimated liability of $0.3 million as of December 30, 2007.

     Determining if the level and nature of business activities are sufficient to create nexus raises complex factual and legal issues and is subject to uncertainties. Management believes that it is not probable that additional jurisdictions will be successful in asserting nexus over the Company, and has therefore not recorded a liability associated with these contingencies. If additional jurisdictions are successful in asserting nexus over the Company, the liability for any prior amounts owed to such jurisdictions may have a material adverse effect on the Company’s financial condition and operating results.

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 21E of the Securities and Exchange Act of 1934. The forward-looking statements contained in this report include, among others, statements regarding our ability to secure additional financing, our ability to continue as a going concern, our ability to re-energize the RedEnvelope brand, the impact of upgrades at our fulfillment center and our ability to achieve profitability. 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 or service

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,” “would,” “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, our inability to secure additional financing, failure of our advertising efforts, our failure to achieve profitability, the seasonality of our business, fulfillment or distribution problems, failure to adequately predict consumer tastes and preferences, those risks set forth in this report under “Risk Factors,” 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

     RedEnvelope is a branded online retailer of upscale gifts, dedicated to inspiring people to celebrate their relationships through giving. RedEnvelope offers an extensive and fresh collection of imaginative and original gifts through our catalog, web store and phone store. Our in-house design team creates unique proprietary products, and our merchants source unique products domestically and from various parts of the world and often commission artists and vendors to create exclusive gifts. Through our web store, www.redenvelope.com, customers can search for gifts by recipient, occasion, gift category and price point. We also publish our full-color catalog several times a year and sell directly to corporate clients through our Business Gifts Services group.

     In the third quarter of fiscal year 2008, our net revenues decreased 20.7% from $57.0 million in the third quarter of fiscal year 2007 to $45.2 million in the third quarter of fiscal year 2008. Gross margin decreased in the third quarter of fiscal 2008 to 48.7% from 54.1% in the third quarter of fiscal year 2007. Our net loss for the third quarter of fiscal 2008 was $4.3 million compared to net income of $5.3 million in the same period of the prior fiscal year. Although we experienced an increase in the average unit retail price and the average revenue per order shipped decreased only slightly, we experienced a 40.9% decrease in new customer acquisitions and a 19.6% decrease in the number of orders shipped as compared to the same period in the prior year. The decline in orders shipped in the third quarter of fiscal 2008 resulted from a decline in customer response rates as compared to the same period in the prior year, as well as a reduction in marketing expenditures for new customer prospecting in the second half of fiscal 2007. As of December 30, 2007, we had approximately 3.6 million customer names in our internal database, representing an increase of approximately 134,000 customers during the third quarter of fiscal 2008.

     For the remainder of fiscal year 2008, we intend to continue to focus on re-energizing the RedEnvelope brand and product offerings in order to realize the potential of our business model. Further, we intend to implement more cost effective marketing, customer acquisition and retention programs and intend to focus on shifting our marketing spend to online channels, which we believe are more efficient in the future. We recently upgraded our material handling equipment in our fulfillment center and we expect that this upgrade will continue to enhance our fulfillment capabilities by providing automated solutions to our fulfillment process and increasing the facility’s capacity.

     We also are focused on addressing our need to strengthen our balance sheet. We are aggressively reviewing our options to obtain additional financing and have multiple discussions underway with a variety of potential partners. We intend to have a resolution for our need for additional capital resources in the next 90 days. However, there can be no assurance that when 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 stockholders. If adequate funds are not available when needed, we may be required to significantly modify our business model to reduce spending to a sustainable level. Such modification of the business model could also result in an impairment of assets which cannot be determined at this time.

     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 results within anticipated timelines or at all. We have outlined currently identified risks within the “Risk Factors” section of this report.

Results of Operations and Liquidity Matters

     Our financial statements have been presented on the basis that we are a going concern, which contemplates the continuity of operations, realization of assets and the satisfaction of liabilities in the ordinary course of business. Based on our cash balance as of December 30, 2007, as well as projected cash flows from operations and projected cash available to us through our Revolving Credit Facility and Subordinated Promissory Note (both further described below and under Note 7), we believe we have the ability to continue our operations through the quarter ending June 29, 2008. Our continuation as a going concern beyond the quarter ending June 29, 2008 is dependent upon our ability to obtain equity and or additional debt financing and upon future profitable operations. However, there can be no assurances that when 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.

     In the thirty-nine weeks ended December 30, 2007, we incurred a net loss of $18.2 million and generated approximately $3.0 million of cash from operating activities. We had cash and cash equivalents of $12.3 million as of December 30, 2007 and $1.8 million as of January 27, 2008. Although we experienced an increase in the average unit retail price and the average revenue per order shipped was flat, we experienced a 31.3% decrease in new customer acquisitions and a 14.2% decrease in the number of orders shipped as compared to the same period in the prior year. The decline in orders shipped in the thirty-nine weeks ended

December 31, 2007 resulted from a decline in customer response rates as compared to the same period in the prior year, as well as a reduction in marketing expenditures for new customer prospecting in the second half of fiscal 2007. We expect these trends to continue in the near term.

     We have the Revolving Credit Facility in place with a lender, which is described more fully in Note 7. As of December 30, 2007, the borrowing base under our Revolving Credit Facility reflected an availability of $3.8 million and we had no borrowings under the Revolving Credit Facility. On June 29, 2007, we executed the Subordinated Promissory Note with a related party that provides for a term loan with availability of up to $2.6 million and expires on June 28, 2008, which is described more fully in Note 7. As of December 30, 2007, we had no borrowings under the Subordinated Promissory Note.

Critical Accounting Policies

     Our condensed 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 management to make estimates and judgments that affect the reported amounts of assets and liabilities and disclosures of contingent assets and liabilities as of the date of the financial statements and reported amounts of revenues and expenses during the reporting period. Actual results could differ from these estimates and such differences could affect the results of operations reported in future periods. There have been no significant changes to the critical accounting policies as discussed in our Annual Report on Form 10-K for the year ended April 1, 2007.

Results of Operations

     The following table sets forth our statements of operations data for the thirteen and thirty-nine weeks ended December 30, 2007 and December 31, 2006, expressed as a percentage of net revenues.

Quarter Ended December 30, 2007 Compared to Quarter Ended December 31, 2006

Net Revenues

     Net revenues are comprised of product sales, shipping revenue, gift-wrap revenue and personalization 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 and personalization revenue consists of amounts we charge our customers for our signature red gift boxes and for personalization of products, respectively.

     Net revenues were $45.2 million and $57.0 million for the thirteen weeks ended December 30, 2007 and December 31, 2006, respectively, representing a 20.7% decrease in the fiscal 2008 period compared to the fiscal 2007 period. The decrease was mainly attributable to a 19.6% decrease in the number of orders shipped and a 40.9% decrease in new customer acquisitions as compared to the same period in the prior year. Our customer file increased by approximately 134,000 names from the end of the second quarter of fiscal 2008 to approximately 3.6 million as of December 30, 2007, compared with an increase of approximately 227,000 names in the same period of the prior year.

     Revenue per order decreased slightly by 1.4% in the third quarter of fiscal 2008 as compared to the third quarter of fiscal 2007. During the third quarter of fiscal 2008, we experienced an increase in the average retail price per item sold as compared to the third quarter of fiscal 2007, a decrease in the average units per order compared with the same period in the prior year, and our online and email revenues increased by approximately 4.8% compared to the third quarter of fiscal 2007. However, due to decreased response rates from existing customers, our revenues from customers who receive our catalog decreased 28.6% over the same period of the prior year.

Cost of Sales

     Cost of sales consists of the cost of the product sold, inbound and outbound freight and gift-wrap expense. Handling costs, which include fulfillment center expenses, are included in operating expenses — fulfillment.

     Cost of sales was $23.2 million and $26.2 million for the thirteen weeks ended December 30, 2007 and December 31, 2006, respectively, representing 51.3% and 45.9% of net revenues, respectively. The increase in cost of sales as a percentage of net revenues primarily reflects a shift in our product mix to include more market product versus internally developed product as well as increased shipping expenses in the third quarter of fiscal 2008 as compared to the same period last year. The decrease in dollars is a result of decreased orders shipped and decreased net revenues as compared to the third quarter of fiscal 2007.

Operating Expenses

      Fulfillment. Fulfillment expenses consist of wages and benefits for employees and seasonal hires working in our distribution center and customer sales and service facility, fees incurred to process credit card transactions and certain fixed costs, such as rent and utilities, incurred at our distribution center and customer sales and service facility.

     Fulfillment expenses were $7.4 million for both the thirteen weeks ended December 30, 2007 and December 31, 2006, representing 16.3% and 13.1% of net revenues, respectively. We were able to maintain operating efficiencies in warehouse management and maintain a consistent level of fixed expenses in the third quarter of fiscal 2008 as compared to the prior year. The increase in fulfillment expenses as a percentage of net revenues reflects the decrease of 20.7% in net revenues in the third quarter of fiscal 2008 as compared to the same period in the prior year.

      Marketing. Marketing expenses consist primarily of online and catalog programs as well as public relations, other promotional expenditures and advertising.

     Marketing expenses were $13.5 million and $12.6 million for the thirteen weeks ended December 30, 2007 and December 31, 2006, respectively, representing 29.8% and 22.1% of net revenues, respectively. The increase in dollars primarily represents increased catalog production and postage costs, and public relations activities as compared to the third quarter of fiscal 2007. These increases were partially offset by reduced and slightly more efficient online advertising spending during the third quarter of fiscal 2008 as compared to the third quarter of fiscal 2007. The increase in marketing expenses as a percentage of net revenues reflects the decrease in our net revenues as well as a decrease in the efficiency of our catalog campaigns during the third quarter of fiscal 2008. Our primary marketing vehicles are subject to increasing costs and competition.

      General and Administrative. General and administrative expenses consist of wages and benefits for all of our employees, except for fulfillment and customer sales and service employees. These expenses also include costs incurred for computer and communications technology, rent and utilities for our headquarters, travel, depreciation, stock-based compensation and other general corporate expenditures.

     General and administrative expenses were $5.5 million for both the thirteen weeks ended December 30, 2007 and December 31, 2006, representing 12.2% and 9.7% of net revenues, respectively. General and administrative expenses for the thirteen weeks ended December 30, 2007 includes a reversal of approximately $0.5 million for bonuses accrued during the first half of fiscal 2008. This reversal was offset by increased personnel costs, including salaries, severance, relocation costs, and increased corporate consulting projects. The increase in general and administrative expenses as a percentage of net revenues primarily reflects the 20.7% decrease in revenues in the quarter ended December 30, 2007 as compared to the same period in the prior year.

Thirty-nine Weeks Ended December 30, 2007 Compared to Thirty-nine Weeks Ended December 31, 2006

Net Revenues

     Net revenues were $85.6 million and $99.4 million for the thirty-nine weeks ended December 30, 2007 and December 31, 2006, respectively, representing a 13.9% decrease from fiscal 2007 to fiscal 2008. The decrease was mainly attributable to a 14.2% decrease in orders shipped and a 31.3% decrease in new customer acquisitions in the first thirty-nine weeks of fiscal 2008 as compared to the first thirty-nine weeks of fiscal 2007. Our customer file increased by approximately 268,000 names from the end of the fourth quarter of fiscal 2007 to approximately 3.6 million as of December 30, 2007, compared with an increase of approximately 390,000 names in the same period of the prior year.

     Revenue per order was flat in the first thirty-nine weeks of fiscal 2008 as compared to the first thirty-nine weeks of fiscal 2007. During the first thirty-nine weeks of fiscal 2008, average retail price per item sold increased as compared to the first thirty-nine weeks of fiscal 2007, average units per order decreased compared with the same period in the prior year, and online and email revenues were flat compared to the first thirty-nine weeks of fiscal 2007. However, due to decreased response rates from existing customers, our revenues from customers who receive our catalog decreased 17.2% in the first thirty-nine weeks of fiscal 2008 compared to the same period in the prior year.

Cost of Sales

     Cost of sales was $45.0 million and $46.6 million for the thirty-nine weeks ended December 30, 2007 and December 31, 2006, respectively, representing 52.6% and 46.9% of net revenues, respectively. The increase in cost of sales as a percentage of net revenues primarily reflects a shift in our product mix to include more market product versus internally developed product, as well as a strong summer sale event during the second quarter of fiscal 2008. The decrease in dollars is a result of the 14.2% decrease in orders shipped and the 13.9% decrease in net revenues in the first thirty-nine weeks of fiscal 2008 as compared to the same period in the prior year.

Operating Expenses

      Fulfillment. Fulfillment expenses were $13.7 million for both the thirty-nine weeks ended December 30, 2007 and December 31, 2006, representing 16.0% and 13.7% of net revenues, respectively. We were able to maintain operating efficiencies in warehouse management and maintain a consistent level of fixed expenses in the first thirty-nine weeks of fiscal 2008 as compared to the prior year. The increase in fulfillment expenses as a percentage of net revenues reflects the decrease of 13.9% in net revenues in the first thirty-nine weeks of fiscal 2008 as compared to the same period in the prior year.

      Marketing. Marketing expenses were $23.4 million and $22.0 million for the thirty-nine weeks ended December 30, 2007 and December 31, 2006, respectively, representing 27.4% and 22.2% of net revenues, respectively. The increase in dollars primarily represents increased catalog production and postage costs, and public relations activities, partially offset by decreased online advertising spending and market research as compared to the same period last year. The increase in marketing expenses as a percentage of net revenues reflects a decrease in the efficiency of our catalog campaign during the first thirty-nine weeks of fiscal 2008. Our primary marketing vehicles are subject to increasing costs and competition.

      General and Administrative. General and administrative expenses were $21.9 million and $16.5 million for the thirty-nine weeks ended December 30, 2007 and December 31, 2006, respectively, representing 25.5% and 16.6% of net revenues, respectively. General and administrative expenses for the thirty-nine weeks ended December 30, 2007 includes a non-cash charge of $3.5 million, or 4.1% of net revenues, representing the write-off related to the decision to terminate development of new website technology. The remaining increase in general and administrative expenses of $1.9 million, or 2.2% of net revenues, was primarily due to increased personnel costs, including salaries, severance, relocation costs, and increased corporate consulting projects during the first thirty-nine weeks of fiscal 2008 as compared to the same period last year, and increased accruals for sales and use tax liabilities.

Liquidity and Capital Resources

     Historically, revenues have been seasonal. Revenues have been higher in the third fiscal quarter, reflecting higher consumer spending during the holiday season. As a result, our cash balances are seasonal in nature, with the third fiscal quarter containing both our lowest level of cash for the year as we build inventory for the holiday selling season, and our highest level of cash upon conclusion of this season. 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 in place the Revolving Credit Facility and the Subordinated Promissory Note described more fully in Note 7 to the financial statements contained in this report.

      Cash Flows From Operating Activities — Net cash flows provided by operating activities were $3.0 million for the thirty-nine weeks ended December 30, 2007 and $15.8 million for the thirty-nine weeks ended December 31, 2006. The change in net cash flows provided by operating activities primarily represents an increase in net loss of $18.9 million offset by a non-cash charge of $3.5 million representing the write-off related to the decision to terminate development of new website technology.

      Cash Flows From Investing Activities — Net cash flow used in investing activities was $3.8 million for the thirty-nine weeks ended December 30, 2007 and net cash provided by investing activities was $4.1 million for the thirty-nine weeks ended December 31, 2006. Cash (used in) provided by investing activities consisted of capital expenditures for property and equipment, as well as purchases and maturities of investments in fiscal 2007. Capital expenditures during the first thirty-nine weeks of fiscal 2008 were approximately $3.9 million for various investments in our fulfillment center and our technology. We are currently investing in our fulfillment center and we currently anticipate spending an additional $0.3 million during the remainder of fiscal 2008. We currently believe these investments will support the needs of our business and customers.

      Cash Flows From Financing Activities — Net cash flow used in financing activities was $0.1 million for the thirty-nine weeks ended December 30, 2007 and net cash provided by financing activities was $0.2 million for the thirty-nine weeks ended December 31, 2006. For both periods, net cash flows from financing activities consisted of proceeds from the exercises of stock options which were offset by payments on capital lease obligations. For the first thirty-nine weeks of fiscal 2007, net cash flows provided by financing activities also included payments for debt issuance costs of $0.1 million in connection with obtaining our Revolving Credit Facility. During the third quarter of fiscal 2008, we borrowed $5.8 million under our Revolving Credit Facility to fund our seasonal inventory build up and repaid these borrowings as of December 12, 2007.

      Revolving Credit Facility — We have in place the Revolving Credit Facility with a lender, which is described more fully in Note 7 to the financial statements contained in this report. As of December 30, 2007, the borrowing base reflected an availability of $3.8 million and we had no borrowings under the Revolving Credit Facility. On June 29, 2007, the Company executed the Subordinated Promissory Note with a related party that provides for a term loan of up to $2.6 million, which is described more fully in Note 7 to the financial statements contained in this report. As of December 30, 2007, we had no borrowings under the Subordinated Promissory Note.

Item 3. Quantitative and Qualitative Disclosures About Market Risk

      Foreign Currency Risk — We purchase a significant amount of inventory from vendors outside of the U.S. in transactions that are generally denominated in U.S. dollars. As of December 30, 2007, 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

      Disclosure Controls and Procedures — We maintain disclosure controls and procedures that are designed to ensure that information required to be disclosed in our Exchange Act reports is (i) recorded, processed, summarized and reported in a timely manner and (ii) accumulated and communicated to management, including our principal executive officer and principal financial officer as appropriate, to permit timely decisions regarding our disclosure. These controls and procedures are designed to provide reasonable assurance of achieving our objectives. We evaluated the design and operation of our 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 under the supervision and with the participation of our management, including our principal executive officer and principal financial officer as of the end of the period being reported on in this Quarterly Report on Form 10-Q. We continue to formalize and document procedures already in place. Maintenance of disclosure controls and procedures is an ongoing process and controls and procedures may change over time. We have also established a Disclosure Committee, which consists of certain members of our senior management. Based on this evaluation, our principal executive officer and the principal 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 we are required to disclose in reports that we file 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 ended December 30, 2007, there have not been any changes to our internal control over financial reporting that have materially affected, or that are reasonably likely to materially affect, our internal control over financial reporting.

PART II.
OTHER INFORMATION

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 our catalog, online marketing programs and 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, the costs of online marketing and the costs of complying with applicable regulations, may limit our ability to advertise and market our business in a cost-effective manner. 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. 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 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 December 30, 2007, our accumulated deficit was $111.2 million and, during the first thirty-nine weeks of fiscal 2008, we incurred a net loss of $18.2 million. We have not achieved profitability for a full fiscal year since our inception. If our revenues grow more slowly than we anticipate, or if our operating expenses exceed our expectations, we may not be able to achieve full fiscal year profitability in the near future or at all. Even if we do achieve full fiscal year profitability, we may not be able to sustain or increase profitability on a quarterly or annual basis in the future. If we are unable to achieve full fiscal year 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.

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 47% of net revenues in the fiscal year ended April 1, 2007. We cannot predict with certainty what percentage of our total net revenues for fiscal year 2008 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, for whatever reason, then increased expenses may not be offset and it would have a disproportionately large negative impact on our annual operating results and financial condition for that fiscal year. Our net revenues for the third quarter of fiscal 2008 were down 20.7% as compared to the third quarter of fiscal 2007. If our net revenues during our third fiscal quarter were to fall below projections or 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 including those discussed in this report, 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 projections or the expectations of securities analysts and investors. In this event, the trading price of our common stock could decline, perhaps significantly.

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. The uninterrupted operation of our computer and communications hardware and software systems may also be dependent upon the continued performance of third party vendors and/or service providers with whom we have contracted. In the event that one of our third party service providers fails for any reason to perform its obligations in a timely or efficient manner, or at all, our operations could be interrupted or adversely affected or we could be required to incur additional, unanticipated costs. Further, our servers are located at the facilities of, and hosted by, a third-party service provider in San Francisco, 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 could be forced to enter into a relationship with

another service provider or take over hosting responsibilities ourselves. During fiscal 2007, we established a failover system at our primary data center for all of our production systems. 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 loss of data or 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 and operating results. And, any significant additional expenses incurred as a result of any failure by a third party to perform obligations in a timely or efficient manner or any significant costs associated with finding a new vendor or service provider or taking over responsibilities ourselves would have an adverse impact on our business, financial condition and operating results.

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.

     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 competitively priced, 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 operating results would be adversely affected.

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. In the past, we have encountered difficulties in the management of our fulfillment and distribution operations, and we may encounter such difficulties in the future. If we are unable to manage successfully our fulfillment and distribution operations and to meet our customers’ expectations regarding personalization, presentation and delivery, our business reputation, operations and financial condition could be seriously harmed. Further, 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 fulfillment facilities. Further, we currently anticipate that we will need to expand and upgrade our fulfillment 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 may be adversely affected.

     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, which could also harm our business and reputation. In prior periods, 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.

     A significant portion of our products are unique designs manufactured by third-parties. However, since we do not have long-term arrangements with any manufacturer, 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 products, our operating results will be harmed.

     In addition, we may not receive products from our suppliers in a timely manner or 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 products 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 do not receive products from our suppliers in a timely manner or 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.

     Many of our products are sourced overseas. While products sourced overseas typically have lower costs, our product margins may be 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. Increasing competition for overseas production resources, particularly in China, may result in higher than anticipated product costs and lower product margins. Furthermore, in recent years, U.S. companies were subject to port strikes which delayed the delivery of goods. 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 would 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, and the majority of our infrastructure, including computer servers, are located in San Francisco, 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 orders are shipped and our customer sales and service facility is located in San Diego, California. 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 inventory and/or data or render us unable to accept and fulfill customer orders in a timely manner, or at all. 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 sales and service facility, have recently experienced severe wildfires. The occurrence of any such wildfires in the future could destroy, render inoperable, or cause the evacuation of our customer sales and service facility, which could significantly impair or disrupt our ability to provide requisite sales and service support. 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 could be seriously harmed.

If we fail to manage our growth or successfully integrate our board or management team, our business will suffer.

     We anticipate that future expansion, including the possible acquisition of third-party assets, technologies or businesses, maybe required to address market opportunities and desired growth in our customer base. Prior expansion has placed, and any future expansion would likely place, a significant strain on our management, operational and financial resources. We have experienced significant turnover among our executive officers and on our board of directors in recent years and several of our executive officers and directors have only been with the Company for a short period of time. As a result, key members of our board and management team are still in the process of being integrated into our operations. Turnover in management personnel can be greatly disruptive to the proper and efficient functioning of an organization and any such past or future turnover could have a material, adverse affect on our operations. 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 or make it more difficult to plan and forecast our business, distract our management and employees or increase our costs. If we are unable to manage growth effectively, including integration of new personnel, implementation of proper controls and systems in an efficient manner, or successful integration of any assets, technologies or businesses that we may acquire, or if we acquire assets, technologies or business that do not prove complimentary to us, our business, financial condition and results of operations would be affected adversely.

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 merchants 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 and eBay
	•		major department stores, such as Macy’s, Bloomingdale’s, Neiman Marcus and their online storefronts
	•		physical and online stores and catalog retailers that sell popular gift items such as Pottery Barn, Brookstone, The Sharper Image, Tiffany’s, Harry & David, J Crew, 1-800-Flowers and Williams-Sonoma
	•		Internet portals and online service providers and other comparison shopping sites, such as AOL, Yahoo! and Google.

     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 effectively 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 affected adversely.

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 any potential growth in customer orders successfully. As a result, we could lose customers and our net revenues could decline. 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 and enhancing our website and other systems entails significant technical and business risks. We recently made a decision to terminate development of certain new website technology. Consequently, we will continue to utilize our existing technology in the near term, seeking to make improvements or enhancements as we deem advisable. We can provide no assurances that our existing or future website technology will continue to meet our needs or contain all of the features sought by consumers. 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 consumer preferences, our operating results would be seriously harmed.

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 disruption or inaccuracy in order, fulfillment, personalization, or delivery for any reason, particularly during the holiday shopping season, could cause us to lose customers and negatively affect our business and reputation. 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 delays due to factors that are beyond our control, including employee strikes and inclement weather.

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. Three of our former officers, Gary Korotzer, our former Chief Marketing Officer, Polly Boe, our former Chief Financial Officer and Ken Constable, our former President and Chief Executive Officer each resigned from RedEnvelope during fiscal 2007. Following Mr. Constable’s departure, John Pound, who has been a Director since August 2005 and Chairman of the Board since February 2007, has assumed the role of Chief Executive Officer. The role of Interim Chief Financial Officer has been filled by William Gochnauer, who is a Member of Tatum LLC, a national firm that provides such executive services. We are not currently engaged in a search for a full-time Chief Financial Officer. In April 2007, we hired Scott Sanborn as our Chief Marketing Officer to fill the position formerly held by Gary Korotzer. In June 2007, Scott Loly resigned as Vice President of Merchandising and this role has been filled by Suzanne Ellis, who was formerly a Director of Merchandising for the Company. Changes in senior management have the potential to be greatly disruptive to our business and it is possible that recent or future changes in management could negatively affect our business. We do not have long-term employment agreements with any of our key personnel. Our performance depends on our ability to retain and motivate other officers and key employees. The loss of the services of key personnel 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 sales and 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 sales and service personnel would harm our business, financial condition and results of operations. Moreover, competition is particularly intense for highly-qualified senior officers in our industry, and a variety of factors could make it difficult for us to attract the right candidates in the near term or at all. In the event that we cannot hire and retain qualified senior officers in a timely manner and retain their services, our business could be adversely affected.

We rely on seasonal and temporary employees during periods of peak activity and any failure by such employees to adequately perform their jobs could adversely affect our operations.

     We depend on temporary and seasonal employees to adequately staff our fulfillment facility and customer sales and service facilities during busy periods such as the holiday shopping season, including individuals responsible for gift personalization and packaging and responding to consumer inquiries. Temporary employees may not have the same levels of training or commitment as full-time employees and, as a result, may be more likely to provide unsatisfactory service. 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 fulfillment and customer sales and service facilities, particularly during the holiday shopping season and other periods of increased activity or if our temporary and seasonal employees do not provide satisfactory service, our operations and sales during such periods could suffer, and our reputation could be harmed.

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
	•		production of aesthetically appealing catalogs
	•		timely delivery of catalog mailings to our customers

     Producing and mailing our catalog entails substantial creative, paper, printing, postage and human labor costs. Increases in the costs of producing and distributing our 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 has recently increased its postage rates and is likely to continue to increase its postage 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. In recent periods, we have experienced slower growth in revenues from our catalog channel

than in our online channels and we expect this trend towards slower catalog growth to continue. If we were to experience an increase in the costs associated with producing or delivering our catalogs or a delay in distributing our catalogs or if our catalogs fail to produce sales at satisfactory levels, our operating results would be adversely affected.

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 creating a favorable interactive customer experience. 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. Because our success depends in large part on keeping our customers satisfied, any failure to provide high levels of customer sales and service or adequately staff our customer sales and service operations would likely impair our reputation and have an adverse effect on our business and operating results.

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. In addition, in many jurisdictions trademark law does not protect the trademark owner from third parties using domain names that are similar to the trademark owner’s registered trademarks and logos. Therefore, we may be unable to prevent third parties from acquiring and using 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 rely on third-party technologies, which may not continue to be available to us on commercially reasonable terms or at all.

     We 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.

Intellectual property and other 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 been subject to claims or received notices from third parties alleging that our trademarks or product offerings and business processes infringe proprietary rights held by them. From time to time we also receive claims, and have previously been a defendant in a lawsuit alleging that our Internet marketing program and website operations infringe patents held by third parties. 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 third-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.

     In addition, it is possible that, in the course of our business, we could be subject to legal claims or proceedings involving consumer, employment, stockholder, contract, product liability or other matters. If we are required to defend against a legal claim or deem it necessary or advisable to initiate a legal proceeding to protect our rights, the expense and distraction of such a claim or proceeding, whether or not resolved in our favor, could adversely affect our business. Further, if a claim or proceeding were resolved against us or if we were to settle any such dispute, we could be required to pay damages or refrain from certain activities, which could have an adverse impact on our business, financial condition and operating results. Additionally, any product liability claims could negatively affect our brand and our reputation.

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. Our business and revenues have been, and in the future could 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, any extended recession or sluggish economy could have a material adverse effect on us.

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.

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. Also, the Board of Directors may determine at some point in the future that it is in our best interests and the best interests of our stockholders to enact additional measures to protect us against unsolicited takeovers or stock accumulation. Such provisions or the enactment of additional protective measures may discourage potential acquirers from making a bid for us, 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 Revolving Credit Facility, 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 Revolving Credit Facility, even if such acquisition would be beneficial to our stockholders.

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 control or 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 and limit the ability of smaller stockholders to influence corporate matters.

The security risks of online commerce, including credit card fraud, may discourage customers from purchasing goods from us.

     During the first thirty-nine weeks of fiscal 2008, approximately 78% of our customer orders were placed through our website. In order for the online commerce market to function and 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, any of which could adversely affect our business.

     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 and financial condition.

Existing or future government regulation could harm our business.

     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, defamation, intellectual property rights, identity theft and information security. The application of existing laws relating to issues such as trademarks, copyrights and other intellectual property issues, taxation, libel, obscenity and personal privacy to the Internet 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. Many of these laws 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.

     States and the federal government are increasingly enacting laws and regulations to protect consumers against identity theft, loss of privacy and misuse of personal user information. These measures impose various and inconsistent requirements on companies collecting and maintaining personal information about consumers. We collect personal information from consumers in the course of doing business. These multiple laws and regulations introduce a considerable measure of uncertainty to our compliance efforts. Such measures will likely increase the costs of doing business and, if we fail to implement appropriate safeguards or we fail to detect and provide prompt notice of unauthorized access as required by some of the new laws, we could be subject to potential claims for damages and other remedies. If we were required to pay any significant amount of money in satisfaction of claims under these laws, 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.

     Several states have enacted several new laws that require all commercial website operators that collect personal information about residents in their states to adopt and post a privacy policy that meets certain specified criteria. Any failure to comply with these new laws could subject us to civil penalties, injunctions, and/or lawsuits. 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, 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, 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 federal 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 (and country to country). 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 (or the laws of any other country), the costs of attempting to comply could be considerable.

We incur significant expenses as a result of being a public company.

     We incur significant legal, accounting, insurance and other expenses as a result of being a public company. The Sarbanes-Oxley Act of 2002, as well as new rules subsequently implemented by the SEC and NASDAQ, has required changes in corporate governance practices of public companies. These new rules and regulations have, and will continue, to increase our legal and financial compliance costs and make some activities more time-consuming and costly. These new rules and regulations have also made, and will continue to make, it more difficult and more expensive for us to obtain director and officer liability insurance.

Our stock price may be volatile, and you may not be able to resell our shares at a profit or at all.

     The trading price of our common stock fluctuates due to the factors discussed in this section and elsewhere in this report. For example, between April 2, 2007 and December 30, 2007, our stock has traded as high as $5.85 and as low as $4.01. In addition, the trading market for our common stock may be influenced by the public float that exists in our stock from time to time. For example, directors, executive officers and significant stockholders control a significant portion of our stock. If any of those individuals were to decide to sell a substantial portion of their respective shares, it would place substantial downward pressure on our stock price. The trading market for our common stock also is influenced by the research and reports that industry or securities analysts publish about us or our industry. If one or more of the analysts who cover us were to publish an unfavorable research report or to downgrade our stock, our stock price likely would decline. If one or more of these analysts were to cease coverage of our company or fail to regularly publish reports on us, we could lose visibility in the financial markets, which in turn could cause our stock price or trading volume to decline.

In the event we are unable to remedy any deficiency we identify in our system of internal controls over financial reporting, or if our internal controls are not effective, our business and our stock price could suffer.

     In preparation for the annual report of management regarding our evaluation of our internal controls that will be required to be included in our fiscal year-end annual report by Section 404 of the Sarbanes-Oxley Act, or Section 404, we adopted a project work plan to assess the adequacy of our internal controls, remediate any deficiency that we may identify, validate that controls are functioning as documented and implement a continuous reporting and improvement process for internal controls. As part of this continuous process, we may discover deficiencies that require us to improve our procedures, processes and systems in order to ensure that our internal controls are adequate and effective and that we are in compliance with the requirements of Section 404.

     If any deficiency we may find from time to time is not adequately addressed, or if we are unable to complete all of our testing and any remediation in time for compliance with the requirements of Section 404 and the SEC rules thereunder, we would be unable to conclude that our internal controls over financial reporting are effective, which could adversely affect investor confidence in our internal controls over financial reporting.

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.

Date: February 13, 2008

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