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UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Form 10-K

Commission file number: 0-50387

RedEnvelope, Inc.

201 Spear Street, 3rd Floor, San Francisco, California 94105

(415) 371-9100

Securities registered pursuant to Section 12(b) of the Act:

Securities registered pursuant to Section 12(g) of the Act:

      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 if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (¶229.405 of this chapter) is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of the Form 10-K or any amendment to this Form 10-K.     Yes o          No þ

      Indicate by check mark whether the registrant is an accelerated filer (as defined in Exchange Act Rule 12b-2 of the Act).     Yes o          No þ

      The aggregate market value of the voting stock held by non-affiliates of the Registrant as of September 26, 2003, was approximately $63.5 million based upon the last sale price reported for such date on the Nasdaq National Market. The Registrant’s common stock commenced trading on September 25, 2003 and the Registrant’s initial public offering closed on September 30, 2003. For purposes of this disclosure, we have assumed the conversion of all shares of the Registrant’s preferred stock, which occurred in connection with the closing of the initial public offering.

      The number of outstanding shares of the registrant’s common stock, $0.01 par value per share, was 8,708,746 as of May 21, 2004.

DOCUMENTS INCORPORATED BY REFERENCE

      The information required by Part III of this Report, to the extent not set forth herein, is incorporated herein by reference from the registrant’s definitive proxy statement relating to the annual meeting of stockholders to be held in 2004, which definitive proxy statement shall be filed with the Securities and Exchange Commission within 120 days after the end of the fiscal year to which this Report relates.

RedEnvelope, Inc.

TABLE OF CONTENTS TO FORM 10-K

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PART I

      This Annual Report on Form 10-K and the documents incorporated herein by reference contain forward-looking statements based on expectations, estimates and projections as of the date of this filing. Actual results may differ materially from those expressed in forward-looking statements. See Item 7 of Part II — “Management’s Discussion and Analysis of Financial Condition and Results of Operations — Forward-Looking Statements.”

Overview

      RedEnvelope is an online retailer of upscale gifts. RedEnvelope’s goal is to make gift giving — no matter what the occasion or circumstance — easy and fun. RedEnvelope offers an extensive collection of imaginative, original gifts for every occasion, recipient and budget. We strive to maintain the highest standards for customer service and gift delivery in an effort to provide our customers with the best possible gift giving experience and to encourage repeat business. We believe that no other online gift retailer offers the combination of ease of shopping, choice of unique, high-quality gifts and superior customer service that we provide through our website and catalog. A cornerstone of our business strategy has been to develop, cultivate and satisfy an attractive and growing customer base. We have developed an internal database of approximately 1.8 million customer names, with approximately 470,000 new customers added in fiscal 2004.

      We strive to offer a wide assortment of high-quality, thoughtful gifts, many of which are difficult to find elsewhere and are not easily replicated. Our merchants travel the world, sourcing unique products and often commission artists and vendors to create exclusive gifts just for RedEnvelope shoppers. Our gift wrap is distinctive and closely associated with our brand. Gift-wrapped products are delivered to the recipient in a branded, high-quality red box with a hand-tied ivory ribbon. We offer a wide assortment of products in fourteen categories, ranging from new baby to jewelry to men’s accessories to home and garden. Our price points range from lower priced items in the $20 to $50 price range intended for broader consumer appeal to higher priced items with more targeted appeal. We believe that our merchandising strategy and product quality enhance our ability to achieve attractive margins on our products.

      Through our website, www.redenvelope.com, customers can search for gifts by occasion, recipient, product category and price point. Our website generally features approximately 650 products, increasing to approximately 800 products during the holiday shopping season. In addition, through our website our customers can register for our gift reminder service, sign up to receive email promotions, view their order history, and request a catalog. In fiscal 2004, approximately 72% of customer orders were placed through our website with the remainder placed through telephone orders. We also publish our full-color catalog several times during the year. Each catalog generally features approximately 130 products, increasing to approximately 250 products during the holiday shopping season, and also serves as the primary advertising vehicle for our Internet operations. During fiscal 2004 and 2003, we mailed approximately 18.8 million and 18.7 million catalogs, respectively, to over 8 million individuals in each period.

      We believe that substantial opportunities exist to grow our business, increase our revenues and achieve profitability by continuing to implement the following strategies:

	•	Improve marketing efficiency — by focusing on the retention of existing customers and emphasizing various online marketing programs
	•	Continue product innovation — by maintaining our mix of 40-50% new products each year
	•	Seek to increase our scale to maximize cost efficiencies — by striving to increase revenues while managing fixed costs and improving fulfillment processes
	•	Acquire new customers — by selective marketing campaigns geared towards capitalizing on our brand recognition

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      RedEnvelope, Inc. was incorporated in California in June 1997 under the name “Giftworks Online, Inc.” and changed its name to “911 Gifts, Inc.” in December 1997. We reincorporated in the State of Delaware under the name “911 Gifts, Inc.” in March 1999 and changed our name to “RedEnvelope, Inc.” in September 1999. We made an election to be treated as an S Corporation for federal and state tax purposes, which remained in effect through February 1999, the day prior to our reincorporation in the State of Delaware in September 1999. We completed our initial public offering in September 2003, and our common stock is listed on the Nasdaq National Market System under the symbol “REDE.”

Merchandising and Sourcing

      Our merchandising group has been designing and developing new products since 2001, as well as finding new product ideas from outside sources. Our merchandising group meets regularly with our merchandise planning staff to review product opportunities, product quality and customer feedback. From these meetings, product ideas are put into design, development and production. In addition, we work with vendors to develop products focusing on unique and innovative features or concepts that distinguish us from competitors. We believe that the appeal of our exclusive products also serves as a key factor in broadening our customer base and strengthening and enhancing our brand appeal. Our goal is to continue to increase sales of these products through the introduction of new, exclusive RedEnvelope products.

      Historically, approximately 50% of our products can be characterized as proprietary. In fiscal year 2004, 61% of the products in our holiday catalog were exclusive to RedEnvelope and our proprietary products were some of our strongest performing products. We currently intend to increase the percentage of exclusive products to approximately 80% over the next several years. We believe that by continually offering innovative, proprietary products, we can better differentiate us from our competitors and can provide a more satisfactory gift-purchasing experience for our customers. In order to provide these levels of proprietary products, our merchandising group works directly with domestic manufacturers, importers and overseas agents to design and manufacture our products. During fiscal 2004, we sourced approximately 33% of our products from overseas. In an effort to increase our proprietary product offering, we will be increasing our overseas product sourcing. We believe working directly with overseas agents and manufacturers will allow us to effectively manage product development and quality. Due to the complexities of overseas sourcing, we have established and have begun staffing an international sourcing group. Since we do not have long-term arrangements with any vendor or distributor that guarantees the availability of products, we do not have a predictable or guaranteed supply of these products in the near future. In addition, while our product development process includes sampling products for quality, there remains the possibility that final production runs will include products that do not meet our quality standards. Due to the lead times of overseas production, we may not be able to receive adequate levels of product that meet our quality standards. If we are unable to provide our customers with continued access to adequate levels of proprietary products that meet our quality standards, our operating results would be harmed. While products sourced overseas typically have lower costs, our product margins may be slightly offset by an increase in inbound freight costs. As security measures around shipping ports increase, these additional costs may result in higher inbound freight costs. Furthermore, in recent years, U.S. companies were subject to port strikes which delayed the delivery of goods. As we increase our overseas sourcing, we face the risk of these delays which could harm our business.

      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.

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Marketing

      We rely primarily on Internet-based online programs and catalog advertising. Revenues to our customers attributable to online Internet-based channels, specifically portals, search, and affiliate derived sales, increased by 44% over the prior fiscal year, which was less than we expected. Revenues attributable to customers who received a catalog increased approximately 9% over the prior fiscal year, even though we mailed approximately the same number of catalogs.

      Currently, we believe the increase in commerce over the Internet will continue for the foreseeable future. However, if consumers are unwilling to use the Internet to purchase retail products, our business will be harmed. In addition, if competitors increase the utilization of online marketing campaigns, the cost of online marketing programs may increase. Moreover, software programs that block certain email marketing campaigns have gained in popularity with individuals. The federal government and certain states have enacted legislation specifically prohibiting or placing significant restrictions on email marketing campaigns. These trends could negatively impact our ability to market to customers through email campaigns.

      We currently intend to use our catalog programs to market our products and brand. However, increases in the cost of catalogs may limit our ability to advertise and market our business without reducing profitability. We plan on exploring other ways to market our products and brand. For example, in the third quarter of fiscal 2004, we launched a series of television advertisements which we believe led to additional interest in our products and catalogs. We are currently considering utilizing other methods of advertising (e.g. print, television, and/or radio). These marketing programs will result in an increase in our marketing costs. Further, the results of advertising will be less predictable than our online and catalog programs. In addition, our limited experience with these methods of advertising may cause us not to achieve the desired results. If such efforts do not produce a sufficient level of sales to cover their costs, it would harm our operating results.

Fulfillment and Distribution

      We lease and operate an approximately 240,000 square foot warehouse and distribution facility in Lockbourne, Ohio. We terminated our relationship with our third-party fulfillment service provider and assumed control of our fulfillment services in August 2003. In the third quarter of fiscal 2004, we experienced delays and errors in the fulfillment process at our distribution center, which prevented us from fulfilling demand for our products. In addition, the anticipated efficiencies from managing the distribution center ourselves did not materialize. Improvements in managing our distribution center will be a key objective in the ensuing months. We are currently in the process of revising certain materials handling processes and implementing new warehouse management software. We believe that these changes will allow us to better manage our fulfillment operations and scale our business. If we are unable to improve the performance of the fulfillment process at our distribution center, we may incur additional labor costs, fail to satisfy demand for our products or experience customer dissatisfaction, any of which could have an adverse affect on our business, financial condition and operating results.

      We do not have any long-term contracts with any manufacturer or supplier and place all of our orders by purchase order. If we fail to obtain sufficient quantities of inventory, it would have a harmful effect on our business, financial condition and results of operations. We have received in the past, and may receive in the future, shipments of products from manufacturers that fail to conform to our quality control standards. In such event, unless we are able to obtain replacement products in a timely manner, we may lose sales which could harm our business and operating results. For a discussion of these and other risks related to our fulfillment and distribution operations, please see “Factors That May Affect Future Results.”

Customer Service

      We lease and operate an approximately 13,000 square foot customer service center in San Diego, California. We are committed to providing our customers with courteous, knowledgeable and prompt service 24 hours a day, seven days a week. Our customer service group in San Diego provide personal attention to customers who call toll free, use Internet chat, or send emails to place orders or inquire about products. Our customer service group is also responsible for addressing customer concerns promptly in an attempt to achieve the customer’s complete satisfaction. We seek to provide a great customer experience and therefore, if a gift

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      We seek to hire and retain qualified customer service representatives and train them thoroughly. Training for customer service representatives focuses primarily on acquiring a working knowledge of our products and of developing an understanding of our high customer service standards.

      Our customer service operations are subject to a number of risks, including disruptions due to power outages, telecommunications or computer system failures, natural disasters and other catastrophic events or an inability to maintain proper levels of competent staffing, the occurrence of any of which could seriously harm our operations. For a description of these and other risks related to our customer service operations, please see “Factors That May Affect Future Results.”

Competition

      We principally compete with a variety of department stores, Internet retailers, specialty retailers and other catalog merchandisers that offer products similar to or the same as our products. Increased competition is likely to result in price reductions, reduced gross margins and loss of market share, any of which could seriously harm our net revenues and results of operations. We expect competition to intensify in the future because current and new competitors can enter our market with little difficulty and can launch new websites at a relatively low cost. We currently or potentially compete with a variety of other companies, including:

	•	other online retailers, such as Amazon.com
	•	major department stores, such as Macy’s, Bloomingdale’s, and Neiman Marcus
	•	physical and online stores and catalog retailers that sell popular gift items such as Pottery Barn, Brookstone, The Sharper Image, Tiffany’s, Harry & David, J Crew, and 1-800-Flowers
	•	Internet portals and online service providers that feature shopping services, such as AOL, Yahoo! and Lycos

      Many of our traditional store-based, catalog-based and online competitors have longer operating histories, larger customer or user bases, greater brand recognition and significantly greater resources, particularly financial and marketing resources. Many of these competitors can devote substantially more resources to website development and catalog retailing than we can. In addition, large, well-established and well-financed entities may establish more robust online sales operations in the future. Our competitors may be able to secure products from vendors on more favorable terms, provide popular products to which we do not have access, fulfill customer orders more efficiently and adopt more aggressive pricing or inventory availability policies than we can.

      The U.S. retail industry, the specialty retail industry in particular, and the online commerce sector are highly competitive, dynamic in nature and have undergone significant changes over the past several years and will likely continue to undergo significant changes. Our ability to anticipate and respond successfully to these changes is critical to our long-term growth and we cannot assure you that we will anticipate and respond successfully to changes in the retail industry and online commerce sectors. If we are unable to maintain or increase our market share or compete effectively in the retail gift market, our business, financial condition and operating results would be adversely affected.

Intellectual Property and Proprietary Rights

      We regard our trademarks, copyrights, domain names, trade secrets and other intellectual property as critical to our success. We rely on various intellectual property laws and contractual restrictions to protect our proprietary rights. These include copyright and trade secret laws and confidentiality, invention assignment and nondisclosure agreements with our employees, contractors, suppliers and strategic partners. Despite these precautions, it may be possible for a third party to copy or otherwise obtain and use our intellectual property without our authorization. “RedEnvelope, Inc.” and certain other trademarks for our business either have been registered or applications are pending with United States Patent and Trademark Office and with certain foreign registries. Effective intellectual property protection may not be available in every country in which our

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      We also rely 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, which could materially adversely affect our business, operating results and financial condition. For a discussion of risks related to intellectual property, see “Factors That May Affect Future Results.”

Information Technology and Systems

      We use third party information technology systems for order fulfillment, merchandising and financial reporting. In addition, we internally developed our webstore and integrated it with these other systems. We are continually making improvements to the overall technology infrastructure to improve the shopping experience and order fulfillment capabilities. We currently use Mail Order and Catalog System (MACS) as our back-end order and fulfillment system.

      Our information technology systems are housed in a leased third-party facility in Santa Clara, California. Currently, we use 28 servers to run our website. Data is stored in a database that runs on a redundant server and storage array. We also have standby servers that can provide additional capacity as necessary. The facility hosting our servers provides redundant heating, ventilation, air conditioning, power and Internet connectivity. In November of 2003, we created a redundant data center in Cincinnati, Ohio. This back-up site is engineered to provide recovery of data within 1 hour.

      We are planning on implementing new software programs for our website, financial, warehouse management, and order entry functions in fiscal year 2005. We believe the implementation of these software systems will support the needs of our business and customers. Software implementation projects entail significant technical and business risks. If we are unsuccessful in implementing these systems, it may hinder our ability to process and fulfill customer orders as well as complete critical financial processing transactions. These projects will result in uses of cash and will result in additional depreciation expense.

      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, terrorist attacks, natural disasters and other catastrophic events, and errors in usage by our employees and customers. In the event that our service provider in Santa Clara has a disruption in its operations or ceases operations for any reason or if we are unable to agree on satisfactory terms for a continued hosting relationship, we would be forced to enter into a relationship with another service provider or take over hosting responsibilities ourselves. We cannot assure you that, in the event it became necessary to switch hosting facilities, we would be successful in finding an alternate service provider on acceptable terms or in hosting the computer servers ourselves. Any significant interruption in the availability or functionality of our website, or our sales processing, fulfillment, distribution or communications systems for any reason, particularly an interruption during the holiday season, could seriously harm our business. For a discussion of these and other risks related to our facilities and systems, see “Factors That May Affect Future Results.”

Seasonality

      Our business is highly seasonal, reflecting the general patterns associated with the retail industry of peak sales and earnings in late November and December during the holiday shopping season. The secondary peak seasons for us are in February and May, reflecting gift buying for Valentine’s Day and Mother’s Day. A substantial portion of our net revenues occurs in the 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. In anticipation of increased sales activity during the third fiscal quarter, we incur significant additional expenses, including significantly higher inventory and staffing costs. Due to the seasonality of our sales, our quarterly results will

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Employees

      As of March 28, 2004, we employed approximately 164 full-time people. We hire temporary employees during the peak seasons. We have never had a work stoppage, and none of our employees is represented by a labor union. We consider our employee relationships to be positive. If we are unable to retain our key employees or if we are unable to maintain adequate staffing of qualified employees, particularly during peak sales seasons, our business would be affected adversely. For a discussion of these and other risks related to our employees, see “Factors That May Affect Future Results.”

Factors That May Affect Future Results

      You should consider carefully the risks and uncertainties relating to our business described below. Additional risks and uncertainties not currently known to us or that we currently do not deem material may also become important factors that may harm our business. The trading price of our common stock could decline due to any of these risks and uncertainties.

      We were originally incorporated in 1997 and began selling products in September 1997. As a result, we have limited historical financial data upon which to base planned operating expenses or forecast accurately our future operating results. Further, our limited operating history will make it difficult for investors and securities analysts to evaluate our business and prospects. You must consider our business and prospects in light of the risks and difficulties we may face as an early stage company with limited operating history. These risks and difficulties include challenges in accurate financial planning as a result of limited historical data and the uncertainties resulting from having had a relatively limited time period in which to implement and evaluate our business strategies as compared to older companies with longer operating histories. Our failure to successfully address these risks and difficulties would seriously harm our business.

      We have a history of losses and we may continue to incur losses for the foreseeable future. As of March 28, 2004, our accumulated deficit was $78.7 million. We have not achieved profitability for a full fiscal year. If our revenues grow more slowly than we anticipate, or if our operating expenses exceed our expectations, we may not be able to achieve profitability in the near future or at all. Even if we do achieve profitability, we may not be able to sustain or increase profitability on an annual basis in the future. If we are unable to achieve profitability within a short period of time, or at all, or if we are unable to sustain profitability at satisfactory levels, our financial condition and stock price could be adversely affected.

      Our business is highly seasonal, reflecting the general pattern of peak sales for the retail industry during the holiday shopping season. Typically, a substantial portion of our net revenues occur during our third fiscal quarter ending around December 31. We generally experience lower net revenues during the first, second and fourth fiscal quarters and, as is typical in the retail industry, have incurred and may continue to incur losses in these quarters. The third fiscal quarter accounted for approximately 45% of net revenues in the fiscal year ended March 28, 2004. We cannot predict with certainty what percentage of our total net revenues for fiscal

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      Our annual and quarterly operating results have fluctuated in the past and may fluctuate significantly in the future due to a variety of factors, many of which are outside of our control. Further, because our business is seasonal, our operating results may vary significantly from one quarter to the next as part of our normal business cycle. As a result, we believe that quarterly comparisons of our operating results are not necessarily meaningful and that you should not rely on the results of one quarter as an indication of our future performance. It is likely that in some future quarter our operating results may fall below the expectations of securities analysts and investors. In this event, the trading price of our common stock could decline significantly.

      Factors that could cause our operating results to fluctuate include the following:

	•	The seasonality of our business
	•	Decreases in the number of visitors to our website or our inability to convert those visitors into customers
	•	Technical difficulties, including system or Internet failures
	•	Fluctuations in the demand for our products
	•	The number of prior customers that make repeat purchases
	•	Overstocking or understocking of our merchandise
	•	Offering of new or enhanced services or more popular products by our competitors
	•	Fluctuations in the level of our product returns
	•	Termination of existing marketing relationships or failure to develop successful new marketing relationships
	•	Fluctuations in shipping costs, particularly during the holiday season
	•	Fluctuations in advertising, marketing or catalog production and distribution costs
	•	Fluctuations in personalization and fulfillment costs
	•	The amount and timing of operating costs and capital expenditures relating to expansion or upgrade of our operations
	•	Changes in government regulations and taxation related to use of the Internet or otherwise applicable to our business
	•	Economic conditions generally or economic conditions specific to the Internet, online commerce, the retail industry, the mail order industry or the gift industry
	•	Changes in the mix of products that we sell
	•	Fluctuations in levels of inventory theft, damage or obsolescence

      Our 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

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      In order to meet our strategic goals, we must successfully offer, on a continuous basis, a broad selection of appealing products. These products must satisfy the diverse tastes of our customers and potential customers for a variety of gift-giving occasions. To be successful, our product offerings must be affordable, well made, innovative and attractive to a wide range of consumers whose preferences may change regularly. We cannot predict with certainty that we will be successful in offering products that meet these requirements. If our products become less popular with consumers, our revenues may decline or fail to meet expected levels or we may decide to offer our products at lower prices. If a wide range of consumers do not find our products attractive or if we are required to reduce our prices, our revenues and earnings may decline or fail to meet expected levels and our stock price could be affected adversely.

      Our fulfillment and distribution operation is located in leased facilities in Lockbourne, Ohio. Our agreement with the fulfillment services company that previously managed the fulfillment and distribution operations at the Lockbourne, Ohio facility expired in August 2003, at which point we assumed direct control of fulfillment and distribution operations. We have no prior experience managing fulfillment and distribution operations and we cannot assure you that we will be successful in this endeavor. We experienced significant difficulties managing the fulfillment and distribution operations during the 2003 holiday season, including difficulties in inventory management and timely gift personalization, and anticipated efficiencies from managing the distribution center ourselves did not materialize during that period. If we are unable to manage successfully our fulfillment and distribution operations and to meet our customers’ expectations regarding personalization, presentation and delivery, our operations and financial condition could be seriously harmed. Any difficulty in managing our fulfillment and distribution operations could require us to find one or more parties to provide these services for us. If we are required to engage one or more service providers, we could incur higher fulfillment expenses than anticipated or incur additional costs for balancing merchandise inventories among multiple distribution facilities. Further, we may need to expand or upgrade our distribution operations in the future to accommodate increases in customer orders, increased demand for personalized products or changes in available technology. If we fail to successfully manage, expand or make necessary upgrades to our fulfillment and distribution operations in a timely and cost-effective manner, it would have a material adverse effect on our business.

      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

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      More than half of our products are unique designs manufactured by third-party suppliers. We enter into exclusive supply agreements for these products to maintain a competitive advantage. However, since we do not have long-term arrangements with any vendor or distributor that would guarantee the availability of products from year to year, we do not have a predictable or guaranteed supply of these products in the future. If we are unable to provide our customers with continued access to popular, exclusive products, our operating results could be harmed.

      In addition, we may receive products from our suppliers that do not meet our quality standards. From time to time, we receive products from suppliers that are of insufficient quality to provide to our customers. Generally the supplier is able to quickly rectify the problem, but occasionally we have been unable to obtain replacement product quickly enough to fulfill all customer orders for such product in a timely manner, particularly with respect to items sourced overseas which tend to have longer delivery lead time requirements. If we receive products from our suppliers that do not meet our high quality standards and we are unable to obtain suitable replacement products in a timely manner, our reputation and our operating results could be harmed. Further, customers who do not receive their products in a timely manner may look to our competitors for their gift items.

      Many of our products are sourced overseas. While products sourced overseas typically have lower costs, our product margins may be slightly offset by an increase in inbound freight costs. As security measures around shipping ports increase, these additional costs may result in higher inbound freight costs. Furthermore, in recent years, U.S. companies were subject to port strikes which delayed the delivery of goods. As we increase our overseas sourcing, we face the risk of these delays which could harm our business and results of operations. We cannot predict whether any of the countries in which our merchandise currently is manufactured or may be manufactured in the future will be subject to additional trade restrictions imposed by the U.S. and other foreign governments, including the likelihood, type or effect of any such restrictions. Trade restrictions, including increased tariffs or quotas, embargoes, and customs restrictions, against items that we offer or intend to offer to our customers, as well as U.S. or foreign labor strikes, work stoppages or boycotts, could increase the cost or reduce the supply of items available to us and adversely affect our business, financial condition and results of operations. Our sourcing operations also may be adversely affected by political and financial instability resulting in the disruption of trade from exporting countries, significant fluctuation in the value of the U.S. dollar against foreign currencies, restrictions on the transfer of funds and/or other trade disruptions. Any disruption or delays in, or increased costs of, importing our products could have an adverse effect on our business, financial condition and operating results.

      Our headquarters, customer service center and the majority of our infrastructure, including computer servers, are located in California, an area that is susceptible to earthquakes and other natural disasters. Our distribution facility, located in Lockbourne, Ohio, houses substantially all of our product inventory and is the

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      We have rapidly and significantly expanded our operations, and anticipate that further significant expansion, including the possible acquisition of third-party assets, technologies or businesses, will be required to address market opportunities and desired growth in our customer base. Prior expansion has placed, and any future expansion is expected to continue to place, a significant strain on our management, operational and financial resources. Some of our officers or senior management personnel have no prior senior management experience at public companies. Our new employees include key officers as well as a number of key managerial, technical and operations personnel who have not yet been fully integrated into our operations. Additionally, we need to properly implement and maintain our financial and managerial controls, reporting systems and procedures, including the increased internal controls and procedures required by the recently enacted Sarbanes Oxley Act of 2002. Moreover, if we are presented with appropriate opportunities, we may in the future make investments in, or possibly acquire, assets, technologies or businesses that we believe are complementary to ours. Any such investment or acquisition may further strain our financial and managerial controls and reporting systems and procedures. These difficulties could disrupt our business, distract our management and employees or increase our costs. If we are unable to manage growth effectively, implement proper controls and systems in an efficient manner, or successfully integrate any assets, technologies or businesses that we may acquire, our business, financial condition and results of operations would be affected adversely.

      We operate in a highly competitive environment. We principally compete with a variety of department stores, Internet retailers, specialty retailers and other catalog merchandisers that offer products similar to or the same as our products. Increased competition is likely to result in price reductions, reduced gross margins and loss of market share, any of which could seriously harm our net revenues and results of operations. We expect competition to intensify in the future because current and new competitors can enter our market with little difficulty and can launch new websites at a relatively low cost. We currently or potentially compete with a variety of other companies, including:

	•	other online retailers, such as Amazon.com
	•	major department stores, such as Macy’s, Bloomingdale’s and Neiman Marcus
	•	physical and online stores and catalog retailers that sell popular gift items such as Pottery Barn, Brookstone, The Sharper Image, Tiffany’s, Harry & David, J Crew, and 1-800-Flowers
	•	Internet portals and online service providers that feature shopping services, such as AOL, Yahoo! and Lycos

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      Many of our traditional store-based, catalog-based and online competitors have longer operating histories, larger customer or user bases, greater brand recognition and significantly greater resources, particularly financial and marketing resources. Many of these competitors can devote substantially more resources to website development and catalog retailing than we can. In addition, large, well-established and well-financed entities may establish more robust online sales operations in the future. Our competitors may be able to secure products from vendors on more favorable terms, provide popular products to which we do not have access, fulfill customer orders more efficiently and adopt more aggressive pricing or inventory availability policies than we can.

      The U.S. retail industry, the specialty retail industry in particular, and the online commerce sector are highly competitive, dynamic in nature and have undergone significant changes over the past several years and will likely continue to undergo significant changes. Our ability to anticipate and respond successfully to these changes is critical to our long-term growth and we cannot assure you that we will anticipate and respond successfully to changes in the retail industry and online commerce sectors. If we are unable to maintain or increase our market share or compete effectively in the retail gift market, our business, financial condition and operating results would be adversely affected.

      If we fail to upgrade our website in a timely manner to accommodate higher volumes of traffic, our website performance could suffer and we may lose customers. In addition, if we fail to expand the computer systems that we use to process and ship customer orders and process customer payments, we may not be able to fulfill customer orders successfully. As a result, we could lose customers and our net revenues could be reduced. Further, to remain competitive, we must continue to enhance and improve the functionality and features of our online store. The Internet and the online commerce industry are subject to rapid technological change. If competitors introduce new features and website enhancements, or if new industry standards and practices emerge, our existing website and systems may become obsolete or unattractive. Developing our website and other systems entails significant technical and business risks. We may use new technologies ineffectively or we may fail to adapt our website, our transaction processing systems and our computer network to meet customer requirements or emerging industry standards. If we are unsuccessful in upgrading our systems to accommodate higher traffic or developing or implementing new technologies that enable us to meet evolving industry standards and remain competitive, our operating results would be seriously harmed.

      We are currently in the process of implementing certain system enhancements and upgrades, including a new warehouse management system, an order-entry system, and an updated financial software package. Also, we are in the process of modifying certain internal processes for the purpose of improving our productivity and making our operations more cost efficient. However, we cannot assure you that we will be successful in these efforts. Possible cost overruns in these implementation efforts may result in higher than anticipated capital expenditures. If we do not successfully implement one or more of these intended upgrades or modified processes or if we do not achieve desired efficiencies or cost savings as a result of these changes, our business and operating results could be harmed.

      As timely gift delivery is essential to our customer’s satisfaction, any delay or disruption in order, fulfillment and shipping, particularly during the holiday shopping season, could cause us to lose customers and negatively affect our business. In addition, we rely upon third-party carriers for timely delivery of our product shipments. As a result, we are subject to carrier disruptions and increased costs due to factors that are beyond our control, including employee strikes, inclement weather and increased fuel costs. Any failure to deliver products to our customers in a timely and accurate manner would damage our reputation and brand and could cause us to lose customers.

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      We also depend on temporary employees to adequately staff our distribution facility during busy periods such as the holiday shopping season, including individuals responsible for gift personalization and packaging. We cannot assure you that we will continue to receive adequate assistance from our temporary employees, or that we will continue to have access to sufficient numbers of competent temporary employees on a cost-effective basis, particularly during the holiday shopping season, which season is critical to our business. If we are unable to adequately staff our distribution and fulfillment facility during the holiday shopping season and other periods of increased activity, our operations and sales during such period could suffer, and our reputation could be harmed.

      As part of our customer service commitment, we maintain a merchandise return policy that allows recipients to return most non-personalized merchandise items received from us if they are dissatisfied with those items. We make allowances for merchandise returns in our financial statements based on historical return rates. We cannot assure you that actual merchandise returns will not significantly exceed our allowances for returns. In addition, because our allowances are based on historical return rates, we cannot assure you that the introduction of new merchandise in our catalogs, the introduction of new catalogs, increased sales over the Internet, changes in our merchandise mix, changes in the habits of our gift item recipients, or other factors will not cause actual returns to exceed return allowances, perhaps significantly. Any increase in merchandise returns that exceed our allowances would affect our business adversely. Also, returned merchandise that is personalized, perishable, or damaged likely cannot be re-sold, creating non-recoverable inventory costs which detrimentally affects our operating results.

      Our catalog has been an important tool for the acquisition and retention of customers. We believe that the success of our catalog as a cost-effective marketing tool depends on the following factors:

	•	effective management of costs associated with the production and distribution of our catalog
	•	achievement of adequate response rates to our mailings
	•	displaying a mix of merchandise in our catalog that is attractive to our customers
	•	cost-effective production of appealing catalogs
	•	timely delivery of catalog mailings to our customers

      Catalog production and mailings entail substantial paper, printing, postage and human labor costs. Increases in the costs of producing and distributing the RedEnvelope catalog, including increases in postage rates or paper, photography, or printing costs, may reduce the margin on sales derived from our catalog. The U.S. Postal Service is likely to increase its postage rates in the future and other delivery and overnight courier services that we utilize to deliver our products also will likely raise their rates in the future, which could significantly increase the aggregate cost of mailing our catalogs . As we incur nearly all of the costs associated with our catalogs prior to mailing, we are unable to adjust the costs being incurred in connection with a particular mailing to reflect the actual performance of the catalog. In addition, response rates to our mailings and, as a result, revenues generated by each mailing, are affected by factors such as constantly changing consumer preferences and our ability to include a product assortment that satisfies those preferences, economic conditions, the timing and mix of catalog mailings, the timely delivery by the postal system of our catalog mailings, and changes in our merchandise mix, several or all of which may be outside of our control. If we were to experience an increase in the costs associated with producing or distributing our catalogs or our catalogs fail to produce sales at satisfactory levels, our operating results would be adversely affected.

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      Our revenues depend on our ability to advertise and market our products effectively through the RedEnvelope catalog and our other advertising and marketing efforts. If we do not successfully advertise and market our products, our operating results will be seriously harmed. Increases in the cost of advertising and marketing, including paper and postage costs and the costs of complying with applicable regulations, may limit our ability to advertise and market our business without reducing our profitability. In addition, individuals are increasingly using software programs that block certain email marketing campaigns, and certain Federal and state laws and regulations may restrict our ability to effectively utilize email as a marketing tool. If we decrease our advertising or marketing activities, or the effectiveness of such activities is diminished, due to increased costs, restrictions enacted by regulatory agencies or for any other reason, our future operating results could be significantly harmed. We expect to increase spending on advertising and marketing in the future, and if such efforts do not produce a sufficient level of sales to cover their costs, it would harm our operating results.

      In August 2003, we changed our shipping rate policy from a graduated rate schedule, based on the cost of the item(s) purchased by a customer, to a consistent flat rate per shipment. This change will have the effect of lowering our average per-shipment shipping fee, thereby reducing our shipping revenues per order. While we believe that this change to our shipping rate policy will be conducive to an increase in our order volume, we cannot assure you that our order volume will be increased or that any increase in shipments will offset the reduction in per-shipment shipping revenues resulting from our shipping rate policy change. We believe that this change in shipping rate policy had an aggregate negative impact on our revenues for the third fiscal quarter of 2004, which was the first full quarter following the policy change, and it is possible that the policy change could have a negative impact on our revenues in future periods. If our aggregate shipping revenues decrease as a result of the change in our shipping rate policy without a commensurate rise in product revenue, our business, financial condition and results of operations could be harmed.

      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. Due to increased customer service needs during the holiday shopping season, we hire a relatively large number of temporary employees during our third fiscal quarter. As a result, we may have difficulty properly staffing our customer service operations during our peak sales season. Further, temporary employees may not have the same levels of training or professional responsibility as full-time employees and, as a result, may be more likely to provide unsatisfactory service to our customers and potential customers. If we are unable to continually provide adequate staffing for our customer service operations, our reputation could be seriously harmed. In addition, we cannot assure you that email and telephone call volumes will not exceed our present system capacities. If this occurs, we could experience delays in placing orders, responding to customer inquiries and addressing customer concerns. Our customer service facility currently accommodates customer service representatives at close to its capacity during our peak sales period. We currently plan on hiring additional customer service representatives in our distribution center in Ohio to accommodate the overflow of calls. Because our success depends in large part on keeping our customers satisfied, any failure to provide high levels of customer service or adequately staff our customer service operations would likely impair our reputation and have an adverse effect on our business and operating results.

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      Our performance is substantially dependent on the continued services and on the performance of our senior management and other key personnel, particularly Alison L. May, our President and Chief Executive Officer. One of our long-time officers and directors, Hilary Billings, recently resigned from RedEnvelope. While we believe that this will have no material impact on our operations, we cannot assure you that disruptions occasioned by her departure will not have an adverse impact on our near-term operations. Our performance also depends on our ability to retain and motivate other officers and key employees. We do not have long-term employment agreements with any of our key personnel. The loss of the services of Ms. May or any of our executive officers or other key employees for any reason could harm our business, financial condition and operating results. Our future success also depends on our ability to identify, attract, hire, train, retain and motivate other highly-skilled technical, managerial, editorial, merchandising, marketing and customer service personnel. Competition for such personnel is intense, particularly in the San Francisco Bay Area, and we cannot assure you that we will be able to successfully attract, assimilate or retain sufficiently qualified personnel. Our failure to attract and retain the necessary technical, managerial, editorial, merchandising, marketing and customer service personnel would harm our business, financial condition and results of operations.

      We regard our copyrights, service marks, trademarks, trade dress, trade secrets and similar intellectual property as critical to our success. We rely on trademark and copyright law, trade secret protection and confidentiality agreements with our employees, consultants, partners, suppliers, and others to protect our proprietary rights. Nevertheless, the steps we take to protect our proprietary rights may be inadequate. Further, effective trademark, service mark, copyright and trade secret protection may not be available in every country in which we will sell our products and offer our services. Currently, we are involved in a trademark dispute with a company based in the United Kingdom regarding trademark rights in the United Kingdom and European Community. For more information on this dispute, see “Part I. Item 3 — Legal Proceedings” below. In addition, the relationship between regulations governing domain names and laws protecting trademarks and similar proprietary rights is unclear. Therefore, we may be unable to prevent third parties from acquiring domain names that are similar to, infringe upon or otherwise decrease the value of our trademarks and other proprietary rights. If we are unable to protect or preserve the value of our trademarks, copyrights, trade secrets or other proprietary rights for any reason, our business would be harmed.

      We also rely substantially on technologies that we license from third parties. These licenses may not continue to be available to us on commercially reasonable terms, or at all, in the future. As a result, we may be required to develop or obtain substitute technology of lower quality or at greater cost, or we may be prevented from providing features or functionality on our website that our customers and potential customers desire, any of which could materially adversely affect our business, operating results and financial condition.

      Other parties may assert infringement or unfair competition claims against us. In the past, we have received notices from third parties alleging that our trademarks or product offerings infringe proprietary rights held by them. We have also in the past received claims and have been a defendant in a lawsuit alleging that our Internet marketing program and website operations infringe patents held by third parties. For additional information on this lawsuit, see “Part I. Item 3 — Legal Proceedings” below. We may receive other similar notices from, or have lawsuits filed against us by, third parties in the future. We cannot predict whether third parties will assert claims of infringement against us, or whether any past, present or future claims will prevent us from offering popular products or operating our business as planned. If we are forced to defend against thirty-party infringement claims, whether they are with or without merit or are determined in our favor, we could face expensive and time-consuming litigation, which could distract technical and management personnel, or result in product shipment delays. If an infringement claim is determined against

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      We are subject to the risk of inventory loss and theft, particularly with respect to our growing line of jewelry products. Although we believe that the levels of inventory shrinkage that we have suffered in the past are within an acceptable range, we cannot assure you that incidences of inventory loss and theft will not increase in the future or that the security measures we have taken in the past will effectively address the problem of inventory theft. If we were to suffer higher rates of inventory shrinkage or incur increased security costs to combat inventory theft, our financial condition could be affected adversely.

      Consumer spending patterns, particularly discretionary spending for products such as ours, are affected by, among other things, prevailing economic conditions, stock market volatility, wars, threats of war, acts of terrorism, wage rates, interest rates, inflation, taxation, and consumer confidence. General economic, political and market conditions, such as recessions, may adversely affect our business results and the market price of our common stock. The terrorist attacks of September 11, 2001 and the wars in Afghanistan and Iraq had a negative effect on an already slowing economy and on consumer confidence. Our business and revenues have been, and could continue to be, negatively affected by poor economic conditions and any related decline in consumer demand for discretionary items such as our products. We face uncertainty in the degree to which poor performance in the retail industry, decreased consumer confidence or any economic slowdown will negatively affect demand for our products. We may not be able to accurately anticipate the magnitude of these effects on future quarterly results, which could seriously harm our financial condition. As we do not have large cash reserves, we may not be able to survive an extended recession or sluggish economy.

      We anticipate that we may need to raise additional capital in the future to facilitate long-term expansion, to respond to competitive pressures or to respond to unanticipated financial requirements. Since our inception, we have experienced negative cash flow from operations on a fiscal year basis and may experience negative cash flow from operations on a fiscal year basis for the foreseeable future. We cannot be certain that we will be able to obtain additional financing on commercially reasonable terms or at all. If we raise additional funds through the issuance of equity, equity-related or debt securities, such securities may have rights, preferences or privileges senior to those of the rights of our common stock and our stockholders will experience dilution of their ownership interests. Further, under the terms of our credit agreement with CapitalSource Finance LLC, we are subject to certain contractual limitations with respect to raising additional capital during the term of that agreement. A failure to obtain additional financing or an inability to obtain financing on acceptable terms could require us to incur indebtedness that has high rates of interest or substantial restrictive covenants, issue equity securities that will dilute the ownership interests of existing stockholders, or scale back, or fail to address opportunities for expansion or enhancement of, our operations.

      We are currently party to a credit agreement that is secured by substantially all of our tangible and intangible assets, and we may enter into secured credit or loan agreements in the future. If we default on our current or any future secured loan for any reason and are unable to cure the default pursuant to the terms of

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      If any of the products that we sell causes harm or financial damages to any of our customers or other individuals, we could be vulnerable to product liability lawsuits. If we are found liable under product liability claims, we could be required to pay substantial monetary damages and our reputation could suffer. Further, even if we successfully defend ourselves against this type of claim, we could be forced to spend a substantial amount of money in litigation expenses, our management could be required to spend valuable time in the defense against these claims and the claims could bring adverse publicity to us, any of which could harm our business.

      We may expand our operations to sell our products internationally, but we have relatively little experience in purchasing, marketing and distributing products or services for international markets. It will be costly to establish international facilities and operations, promote our brand internationally, and develop localized websites, catalogs and other systems. Governments in other countries may regulate Internet or other online services in such areas as content, privacy, network security, encryption or distribution, which could significantly affect our ability to conduct business in those countries. If we are unsuccessful in our attempts to expand our operations into other countries, our operating results could be harmed.

      We 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.

      We are required to verify the age of purchasers of our tobacco products. If we fail to request or are unable to properly identify the age of our purchasers, we could face substantial penalties and legal liability for sales of tobacco products to underage persons. Any inquiry or investigation from a regulatory authority could have a negative impact on our reputation and any liability claims could subject us to fines, mandatory damages or require us to spend significant time and money in litigation, any of which could adversely affect our business, financial condition and operating results.

      We are a Delaware corporation and the Delaware General Corporation Law contains certain provisions that may make a change in control of our company or the removal of incumbent directors more difficult. In addition, our Amended and Restated Certificate of Incorporation and Bylaws, contain provisions that may have the same effect, including the elimination of the ability of stockholders to call special meetings or vote by written consent, the elimination of cumulative voting for directors, and procedures requiring advance notification for stockholder proposals. The elimination of cumulative voting substantially reduces the ability of minority stockholders to obtain representation on the Board of Directors. These provisions may discourage potential acquirers from making a bid for our company, or make an acquisition of us or a tender offer to our stockholders more difficult, even if such acquisition or tender offer would be beneficial to our stockholders, and may reduce any premiums paid to stockholders for their common stock.

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      Additionally, under the terms of our credit agreement with CapitalSource Finance LLC, we are subject to covenants that could restrict or place limitations on our ability to be acquired by another company during the term of the credit agreement, even if such acquisition would be beneficial to our stockholders.

      Our future revenues and profits, if any, substantially depend upon the continued widespread use of the Internet as an effective medium of commerce and communication. Factors which could reduce the widespread use of the Internet include:

	•	actual or perceived lack of privacy protection
	•	actual or perceived lack of security of credit card information
	•	possible disruptions or other damage to the Internet or telecommunications infrastructure
	•	increased governmental regulation and taxation
	•	decreased use of personal computers

      Any decrease or less than anticipated growth in Internet usage could significantly harm our business.

      Approximately 72% of our products currently are purchased through our website. Our long-term prospects therefore depend upon the general public’s increasing willingness to use the Internet as a means to purchase goods. The failure of the Internet to continue to develop into an effective and reliable tool for consumer purchases would seriously damage our future operations. Online commerce is a relatively new concept, and online purchases may decline or fail to increase as projected. The future of online commerce is highly uncertain, many online commerce companies have ceased operations in recent years and most existing online commerce companies have a relatively short operating history. If consumers are unwilling to use the Internet to purchase retail products, our business will be harmed.

      In order for the online commerce market to develop successfully, we and other market participants must be able to transmit confidential information, including credit card information, securely over public networks. Third parties may have the technology or know-how to breach the security of customer transaction data. Any breach could cause consumers to lose confidence in the security of our website and choose not to purchase from us. Although we take the security of our systems very seriously, we cannot guarantee that our security measures will effectively prohibit others from obtaining improper access to our information and information of our customers. If a person is able to circumvent our security measures, he or she could destroy or steal valuable information or disrupt our operations. Any security breach could expose us to risks of data loss, litigation and liability and could seriously disrupt our operations and harm our reputation.

      We do not carry insurance against the risk of credit card fraud, so the failure to prevent fraudulent credit card transactions could reduce our net revenues and gross margin. We may suffer losses as a result of orders placed with fraudulent credit card data even though the associated financial institution approved payment of the orders. Under current credit card practices, we may be liable for fraudulent credit card transactions because we do not obtain a cardholder’s signature. If we are unable to detect or control credit card fraud, our liability for these transactions could harm our business, operating results or financial condition.

      We do not currently collect sales or other similar taxes for physical shipments of goods into states other than California and Ohio. In the future, one or more local, state or foreign jurisdictions may seek to impose

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      We are subject to the same federal, state and local laws as other companies conducting business on the Internet, including consumer protection laws, user privacy laws and regulations prohibiting unfair and deceptive trade practices. In particular, under federal and state financial privacy laws and regulations, we must provide notice to our customers of our policies on sharing non-public information with third parties, must provide advance notice of any changes to our privacy policies and, with limited exceptions, must give consumers the right to prevent sharing of their non-public personal information with unaffiliated third parties. Further, the growth of online commerce could result in more stringent consumer protection laws that impose additional compliance burdens on us. Today there are an increasing number of laws specifically directed at the conduct of business on the Internet. Moreover, due to the increasing use of the Internet, many additional laws and regulations relating to the Internet are being debated at the state and federal levels. These laws and regulations could cover issues such as freedom of expression, pricing, consumer privacy, fraud, quality of products and services, taxation, advertising, adult-oriented content, intellectual property rights and information security. Applicability of existing laws to the Internet relating to issues such as trademarks, copyrights and other intellectual property issues, taxation, libel, obscenity and personal privacy could also harm our business. For example, United States and international laws regulate our ability to use customer information and to develop, buy and sell mailing lists. The vast majority of these laws were adopted prior to the advent of the Internet, and do not contemplate or address the unique issues raised by the Internet. Those laws that do reference the Internet, such as the Digital Millennium Copyright Act and the recent federal law regulating the commercial use of e-mail (popularly known as “CAN-SPAM”), are only beginning to be interpreted by the courts and their applicability and reach are therefore uncertain. The restrictions imposed by, and costs of complying with, current and possible future laws and regulations related to our business could harm our business, operating results and financial condition.

      Tax authorities in a number of states, as well as a Congressional advisory commission, are currently reviewing the appropriate tax treatment of companies engaged in online commerce, and new state tax regulations may subject us to additional state sales and income taxes, which could have an adverse effect on our cash flows and results of operations. Further, there is a possibility that we could be subject to significant fines or other payments for any past failures to comply with these requirements. In its most recent session, Congress refused to extend the U.S. Internet tax moratorium. Consequently, states are free to impose new taxes on Internet access, which could slow the growth of Internet use and of electronic commerce transactions over the Internet.

      The State of California recently enacted a law that requires any company that does business in California and possesses computerized data, in unencrypted form, containing certain personal information about California residents to provide prompt notice to such residents if that personal information was, or is reasonably believed to have been, obtained by an unauthorized person such as a computer hacker. The law defines personal information as an individual’s name together with one or more of that individual’s social security number, driver’s license number, California identification card number, credit card number, debit card number, or bank account information, including any necessary passwords or access codes. As our customers, including California residents, generally provide information to us that is covered by this definition of personal information in connection with their purchases via our website, our business will be affected by this new law. As a result, we will need to ensure that all computerized data containing the previously-described personal information is sufficiently encrypted or that we have implemented appropriate measures to detect

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      Further, recently-enacted federal and state laws place restrictions on email marketing that could make it more difficult for us to acquire new customers, or to obtain repeat purchases from prior customers through inexpensive electronic marketing methods. The CAN-SPAM Act, for example, requires every commercial e-mail message to include an “opt-out” mechanism and requires all senders to comply with their recipients “opt out” requests. It also requires senders to label all commercial e-mail messages as advertisements or solicitations. These requirements may reduce the effectiveness of our e-mail marketing activities. If any current or future law requires us to eliminate or curtail our email marketing efforts, our ability to obtain new customers and increase revenues could be adversely affected or we could incur greater marketing costs, either of which could harm our business. While we intend to comply with applicable law regarding email marketing, there is no assurance that we will not incur fines or other liability as a result of an inadvertent violation of such a law.

      In addition, because our website is accessible over the Internet in multiple states and other countries, we may be subject to their laws and regulations or may be required to qualify to do business in those locations. We are qualified to do business only in California and Ohio at present. Our failure to qualify in a state or country where we are required to do so could subject us to taxes and penalties and we could be subject to legal actions and liability in those jurisdictions. The restrictions or penalties imposed by, and costs of complying with, these laws and regulations could harm our business, operating results and financial condition. Our ability to enforce contracts and other obligations in states and countries in which we are not qualified to do business could be hampered, which could have a material adverse effect on our business. Further, an important aspect of the new Internet-focused laws is that where federal legislation is absent, states have begun to enact consumer-protective laws of their own and these can vary significantly from state to state. Thus, it is difficult for any company to be sufficiently aware of the requirements of all applicable state laws and it is also difficult or impossible for any company to comply fully with the sometimes inconsistent standards and requirements set by various states. In addition to the consequences that could result from violating one or more state laws, the costs of attempting to comply could be considerable.

      We are subject to increasing regulation relating to privacy and the use of personal user information. For example, we are subject to various telemarketing laws that regulate the manner in which we may solicit future suppliers and customers. Such regulations, along with increased governmental or private enforcement, may increase the cost of growing our business. California recently enacted a law, currently scheduled to take effect on July 1, 2004, that will require all commercial website operators that collect personal information about California residents to adopt and post a privacy policy that meets certain specified criteria. Any failure to comply with this new law could subject us to civil penalties, injunctions, and/or lawsuits. In addition, several states have proposed legislation that would limit the uses of personal user information gathered online or require online services to establish privacy policies. The Federal Trade Commission has adopted regulations regarding the collection and use of personal identifying information obtained from children under 13 years of age. Bills proposed in Congress would extend online privacy protections to adults. Moreover, proposed

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      As a publisher of catalogs and online content, we face potential liability for defamation, negligence, intellectual property infringement, or other claims based on the information and other content contained in our catalogs and website. In the past, parties have brought these types of claims and sometimes successfully litigated them against online services. If we incur liability for our catalog or online content, our financial condition could be affected adversely and our reputation could suffer.

      Our directors, executive officers and current beneficial holders of 5% or more of our outstanding common stock own a significant portion of our stock. These stockholders, acting together, are able to influence significantly all matters requiring stockholder approval, including the election of directors and significant corporate transactions such as mergers or other business combinations. This control may delay, deter or prevent a third-party from acquiring or merging with us.

      The following table sets forth certain information regarding our executive officers and key employees as of June 22, 2004.

      Alison L. May has served as the President, Chief Executive Officer and a member of our Board of Directors since April 2002. Prior to joining RedEnvelope, from March 2001 to April 2002, Ms. May served as the Chief Operating Officer at Gymboree Corporation, a children’s specialty retailer. Ms. May held the positions of President and Business Consultant at ALM Consulting from February 2000 to March 2001. From January 1997 to February 2000, Ms. May served as the Chief Operating Officer at Esprit de Corp., a clothing retailer. Ms. May served as the President and Chief Financial Officer of Patagonia, Inc., an outdoor clothing and equipment retailer, from December 1991 to April 1996. Ms. May holds an MBA in Finance from the University of Southern California and a BA in Spanish, Education, and History from Purdue University.

      Eric C. Wong has served as Chief Financial Officer of RedEnvelope since April 2003. Prior to that, Mr. Wong served as our Vice President of Finance from February 2003 to April 2003 and as our Director of Finance from November 2002 to February 2003. From February 2000 to July 2002, Mr. Wong served as the Director of Finance at Network Associates, Inc., an enterprise software company. From December 1997 to February 2000, Mr. Wong served as a Finance Manager at Sanmina Corporation, an electronics manufacturer.

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      Kristine N. Dang has served as General Merchandising Manager at RedEnvelope since April 2003. Prior to that, Ms Dang served as the Vice President of Merchandising at RedEnvelope from March 2000 to April 2003 and served as the Director of Merchandising at RedEnvelope from July 1998 to March 2000. Prior to joining RedEnvelope, from April 1997 to June 1998, Ms. Dang served as an Assistant Buyer at Williams-Sonoma, Inc., a specialty home furnishing retailer. Ms. Dang studied fashion design at San Francisco State University.

      Kathy M. Herzog has served as our Vice President of Planning since April 2003 and served as our Director of Merchandise Planning from January 2002 to April 2003. Prior to joining RedEnvelope, from August 2001 to December 2001, Ms. Herzog served as a Project Manager with GlobalNetXchange, a retail technology company. Ms. Herzog also served as the Director of Planning at Bluelight.com L.L.C., an online retail unit of Kmart Corporation, from January 2001 to July 2001. From March 2000 to December 2000, Ms. Herzog served as a Group Manager at Escalate, Inc., a retail software company. Ms. Herzog also served as a Project Manager at Williams-Sonoma, Inc., a specialty home furnishing retailer, from February 1999 to February 2000, a Planning and Inventory Manager at Williams-Sonoma, Inc. from March 1998 to January 1999 and a Senior Planner at Williams-Sonoma, Inc. from August 1996 to February 1998. Ms. Herzog holds a BA in Business Marketing and an MBA in Business Management from Pacific Lutheran University.

      Christopher E. Nordquist has served as General Counsel of RedEnvelope since October 2003. Prior to joining RedEnvelope, from June 2001 to October 2003, Mr. Nordquist served as Chief Operating Officer of Asset Management Business at Thomas Weisel Partners, an investment bank, and from July 2000 to June 2001 as General Counsel of an asset management joint venture between Thomas Weisel Partners and Scudder Investments. From January 2000 to July 2000, Mr. Nordquist served as General Counsel at WR Hambrecht, an investment bank. From July 1998 to January 2000, Mr. Nordquist also served as Sr. Council at Barclays Global Investors, an institutional asset management firm. Mr. Nordquist received a BA in Economics from St. Olaf College and a JD from Boalt Law School at University of California at Berkeley.

      John W. Roberts has served as our Senior Vice President of Information Technology since July 2003 and our Vice President of Information Technology from March 2003 to July 2003. Prior to joining RedEnvelope, from July 2002 to March 2003, Mr. Roberts served as Vice President of Information Technology at Bridgespan, Inc., a mortgage services company. From November 2000 to June 2002, Mr. Roberts served as a Senior Director and Chief Information Officer at DiCarta, Inc., an enterprise software company. Mr. Roberts also served as a Director of Information Technology Operations at Webvan Group, Inc., an online retail grocer, from January 1998 to August 2000. Mr. Roberts received a BA in English from San Francisco State University and an MS in Systems Management from the University of Denver.

      Edward M. Schmults has served as our Senior Vice President of Operations since May 2004. Prior to joining RedEnvelope, Mr. Schmults served as a consultant for YOOX, an Italian web-based retailer of high fashion apparel and footwear. From November 2000 to February 2003, Mr. Schmults served as President of Global Accounts at Freeborders, an enterprise software company. From November 1997 to March 2000, Mr. Schmults served as President of Moonstone Mountain Equipment, a high-end outdoor apparel company. From 1990-1997, Mr. Schmults held several executive positions at Patagonia, including COO, CIO, and Managing Director of Patagonia Japan, where he oversaw all aspects of the retail, catalog and wholesale business. Mr. Schmults holds a MBA from Harvard University and a BA in Economics and Political Science from Yale University.

      As of March 28, 2004, we leased approximately 16,500 square feet of headquarters office space in San Francisco, California. This lease expires on September 30, 2004, and we are currently negotiating a new lease for our headquarters in San Francisco, California. Also, as of March 28, 2004 we leased approximately 240,000 square feet of distribution space located in Lockbourne, Ohio and approximately 13,000 square feet for our customer service center located in San Diego, California. We believe these facilities and the new

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      Our information technology systems are housed in a leased third-party facility in Santa Clara, California. Currently, we use 28 servers to run our website. Data is stored in a database that runs on a redundant server and storage array. We also have standby servers that can provide additional capacity as necessary. The facility hosting our servers provides redundant heating, ventilation, air conditioning, power and Internet connectivity. In November of 2003, we created a redundant data center in Cincinnati, Ohio. This back-up site is engineered to provide recovery of data within 1 hour. For a discussion of the risks related to disruption in services at our third-party facility in Santa Clara and other facility-related risks, see “Factors That May Affect Future Results.”

      By its letter dated March 9, 2000, Red Letter Days Plc, a United Kingdom company (Red Letter Days), asserted trademark rights in the United Kingdom in the marks RED LETTER, RED LETTER DAYS and the image of a red envelope. Red Letter Days offers experiential gifts in the United Kingdom. The letter claimed that if we were to use our name and the REDENVELOPE service mark in the United Kingdom in connection with retail sales of gifts, it would infringe Red Letter Days’ trademark rights. We have made a number of attempts to reach an amicable resolution of this dispute, but Red Letter Days has declined, to date, to enter into settlement negotiations. Red Letter Days has opposed our applications to register the REDENVELOPE and RedEnvelope stylized logo marks in the United Kingdom and the European Community. Red Letter Days’ oppositions to our United Kingdom and European Community trademark applications are pending. Evidentiary submissions have been made by the parties in connection with those opposition proceedings and a decision is not expected for several months. The sole issue to be decided in the opposition proceedings is whether the REDENVELOPE mark is entitled to registration in the stated jurisdictions. Even if an opposition is successful in preventing the subject trademark from being registered, that decision by the registration authorities does not prevent the applicant from using the mark in that jurisdiction. In order to prevent us from using the RedEnvelope mark in the United Kingdom or European Community or to obtain any other equitable relief or monetary relief, Red Letter Days would need to bring a lawsuit against us in the appropriate jurisdiction. To the best of our knowledge, no such lawsuit has been filed. We opposed Red Letter Days application to register the RED LETTER mark in the United Kingdom, based on the descriptiveness of the RED LETTER mark as applied to the services of Red Letter Days. The United Kingdom trademark office has denied our opposition and has approved the registration of the Red Letter Days mark in the United Kingdom. This decision did not address a comparison of the REDENVELOPE and RED LETTER marks.

      On September 3, 2003, Activ8now, LLC filed a patent infringement lawsuit against the Company in the United States District Court, Northern District of Georgia. The lawsuit alleged a cause of action for infringement of U.S. Patent Nos. 6,535,889 and 6,557,006 based on the theory that certain of our website operations were covered by such patents. On June 18, 2004, the Company and Activ8now, LLC entered into a settlement agreement providing the Company with a non-exclusive, irrevocable, paid-up, worldwide license to such patents in exchange for a one-time fee and dismissal of the lawsuit with prejudice. The settlement did not have a material adverse effect on the Company’s financial position or results of operations.

      There were no matters submitted to a vote of security holders during the fourth quarter of the 2004 fiscal year.

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PART II

      Our common stock began trading on the Nasdaq National Market System on September 25, 2003 under the symbol REDE. The following table sets forth the high and low closing prices for the periods indicated.

      On May 21, 2004, the closing sales price of our common stock on the Nasdaq National Market System was $8.32.

      On September 24, 2003, a Registration Statement on Form S-1 (Commission File No. 333-106120) relating to our initial public offering was declared effective by the Securities and Exchange Commission. The net proceeds to us from the offering were approximately $29.0 million after deducting underwriting discounts of $1.8 million. We used approximately $1.5 million of the net proceeds for fees related to the offering (excluding banker fees). Since the initial public offering, we have used approximately $2.0 million for purchases of property and equipment. We also use the net proceeds to fund our working capital requirements throughout the year.

Stockholders

      The number of stockholders of record as of May 21, 2004 was approximately 137. This number excludes beneficial stockholders whose stock is held in nominee or street name by brokers.

Dividend Policy

      We have never declared nor paid, and do not currently intend to pay, a cash dividend on our common stock. We currently expect to retain future earnings, if any, for use in the operation and expansion of our business and do not anticipate paying any cash dividends in the foreseeable future. Our credit agreement with CapitalSource Finance LLC contains covenants that limit our ability to pay dividends; see also “Item 7 — Management’s Discussion and Analysis of Financial Condition and Results of Operations — Liquidity and Capital Resources.”

Equity Compensation Plan Information

      The information required hereunder is incorporated by reference. Please refer to Exhibit 10.20: 1999 Stock Plan, as amended on April 11, 2003, and form agreements thereunder, Exhibit 10.21: 2003 Directors’ Stock Option Plan and form agreements thereunder, and Exhibit 10.22: 2003 Employee Stock Purchase Plan and form agreements thereunder.

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      The table below shows selected financial data for our last five fiscal years. Our fiscal year is based on a 52 or 53 week year and ends on the Sunday closest to the last day in March. The following selected financial data should be read in conjunction with the financial statements and the notes thereto on Item 8 of Part II, “Financial Statements and Supplementary Data,” and the information contained in Item 7 of Part II, “Management’s Discussion and Analysis of Financial Condition and Results of Operations.” Historical results are not necessarily indicative of future results.

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      The following discussion should be read in conjunction with Item 1 of Part 1 “Business — Factors That May Affect Future Results” and Item 8 of Part II, “Financial Statements and Supplementary Data.”

Forward-Looking Statements

      This report, together with the documents incorporated herein by reference,contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities and Exchange Act of 1934, as amended. Such statements are based upon current expectations and involve risks and uncertainties. Any statements contained in this report that are not purely statements of historical fact may be deemed to be forward-looking statements. Such forward-looking statements may include but are not limited to statements regarding our future operations and enhancements, product offerings, business, financial condition, results of operations and prospects. Additionally, statements concerning possible changes in applicable rules or legislation are forward-looking statements. Words such as “expects,” “anticipates,” “intends,” “plans,” “believes,” “seeks,” “estimate,” “may,” “should,” “could” and similar expressions or variations of such words are intended to identify forward-looking statements, but are not the exclusive means of identifying forward-looking statements in this report. All forward-looking statements in this report are based upon information available to us as of the date hereof, and we assume no obligation to revise or update any such forward-looking statements in order to reflect any event or circumstance that may arise after the date of this report. Actual results and the timing of certain events could differ materially from our current expectations. Factors that could cause or contribute to such differences include, but are not limited to, those set forth above in this report under “Factors That May Affect Future Results,” and elsewhere in this report, and those contained from time to time in our other filings with the SEC. We caution investors that our business and financial performance are subject to substantial risks and uncertainties.

Overview

      In fiscal year 2004, our net revenues increased 13.2% to $79.3 million. Gross margins increased to 50.1% from 47.8% in fiscal year 2003. Our net loss decreased to $5.1 million compared to $7.7 million in the prior fiscal year. On September 30, 2003, we completed our initial public offering whereby we sold 2.2 million shares of our common stock at $14 per share and received proceeds of approximately $29.0 million (after underwriters’ discounts of $1.8 million). Total related offering expenses were approximately $1.5 million, excluding underwriter’s discounts.

      As we attempt to grow our business, our marketing campaigns are an integral part of accomplishing this goal. The challenges associated with marketing include determining the appropriate amount to spend in order to generate additional net revenues, and the allocation of resources between our different marketing channels. We constantly need to balance our efforts to grow our net revenues with the impact on profitability. In fiscal year 2004, we sought to improve the efficiency of our marketing campaigns, by increasing our marketing spend for online marketing programs which had lower marketing cost as a percentage of revenues than our catalog programs. We also sought to improve the performance of our catalogs. While we circulated roughly the same number of catalogs as the prior fiscal year, we introduced two new catalogs: one dedicated solely to jewelry products which was introduced in the first quarter of fiscal 2004 and one featuring non-seasonal gifts for all occasions which debuted in second quarter of fiscal 2004. We partially offset the costs associated with these incremental catalogs by reducing the prospecting for new customers through our Holiday catalog by approximately 2.0 million catalogs.

      We terminated our relationship with our third-party fulfillment services provider and assumed control of our fulfillment services in August 2003. In fiscal year 2004, we experienced some operational execution issues. In the third quarter of fiscal 2004, conservative inventory purchasing, operational difficulties in our fulfillment center and sourcing problems with respect to some of our products led to our inability to satisfy customer demand. Specifically, we experienced delays and errors in the fulfillment process at our fulfillment center, which prevented us from fulfilling demand for our products. In addition, the anticipated efficiencies from managing the fulfillment center ourselves did not materialize. Improvements in managing our fulfillment

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      For fiscal year 2005, our efforts will be focused largely around the following three strategic initiatives: improving the operational execution throughout our supply chain including our fulfillment center; expanding our marketing campaigns, and continued development and expansion of our unique and proprietary product assortment. We believe investment in these initiatives will result in higher top line growth, scalability, and increased efficiency of our operations. Moreover, we believe these investments are vital to support the future growth of the Company.

      To improve our operational execution, we will make investments in our warehouse management systems and training programs at our fulfillment center. We are also in the process of improving our materials handling processing by implementing RF scanning, additional conveyors and layout modifications at the fulfillment center. Additionally, to support our increased overseas sourcing and more actively manage our increasingly diverse manufacturing base, we have created an internal sourcing team to improve the management of our supply chain. We believe that these initiatives will increase our order fulfillment rates, reduce customer return rates, and improve inventory management.

      In developing our expanded marketing strategy, we identified the positives and negatives of online and catalog marketing campaigns. Online marketing can be an efficient means to acquire new customers. However, there are limitations under this approach in communicating our brand image as online marketing programs may be limited to key word search results or banner advertisements that only display our logo. Moreover, while e-mail campaigns can be an efficient program for acquiring and retaining customers, the advent of spam filtering programs and increased government regulation concerning e-mail marketing may cause e-mail marketing campaigns to be less effective and/or more expensive in the future. By circulating catalogs, we are able, in general, to communicate our brand image more effectively than online programs through the use of lifestyle and product pictures. However, customer acquisition through catalog campaigns can be less profitable than other marketing channels. We expect to continue utilizing these types of marketing campaigns while continually monitoring the effectiveness of these campaigns.

      As a result of these factors, we also plan to compliment our existing marketing campaigns with other means of advertising aimed at increasing brand awareness with new customers as well as retention of existing customers. While we have not finalized the methods of advertising, the campaigns could include print, television, or radio. We anticipate the costs of marketing through these methods will be higher than catalog and online marketing alone. These marketing campaigns are expected to occur in the second half of our fiscal year. In addition, the costs to develop these marketing campaigns will be made in advance of the expected revenue stream. We are also currently developing a catalog for corporate gift-giving that includes specific products and creative marketing designed for the corporate customer.

      In addition, to support the future growth of our business, we will be making investments in areas such as merchandising and product development. We believe investing in these areas will provide customers with affordable upscale, modern and unique gifts.

      Fiscal year 2005 will be our first full year as a public company and, as a result, we expect the costs of compliance will be higher than in our prior fiscal year.

      Although we are committed to our strategic initiatives, there are inherent risks associated with our business that may present challenges for us in the future and could prevent us from achieving intended revenue growth, scalability and increased efficiencies. We have outlined currently identified risks within the “Factors That May Affect Future Results” section of this Annual Report on Form 10-K. In addition, the

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Critical Accounting Policies

      Our financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. Our critical accounting policies are set forth below.

      Revenue recognition. We derive our revenues from merchandise sales made to consumers and businesses. We generally require payment by credit card prior to shipment. We recognize revenue on the date on which we estimate that the product has been received by the customer and any payments received prior to the estimated date of receipt of the goods by the customer are deferred. We use our third-party freight carrier information to estimate when delivery has occurred. Revenues are recorded net of estimated returns, coupons redeemed by customers, and other discounts. Significant management judgments and estimates must be made and used in connection with determining revenue recognized in any accounting period. In particular, our management must make estimates of potential future product returns related to current period revenue. We analyze historical returns, current economic trends and changes in customer demand and acceptance of our products when evaluating the adequacy of the sales returns and other allowances in any accounting period. Actual returns may differ materially from our estimated reserve. As a result, our operating results and financial condition could be affected adversely. The reserve for returns was $0.2 million and $0.1 million as of March 28, 2004 and March 30, 2003, respectively.

      Shipping and Handling Costs. Shipping costs, which include inbound and outbound freight costs and the cost of gift wrap, are included in cost of sales. Handling costs, which include fees paid to our former third-party fulfillment service provider and distribution center expenses, are included in operating expenses — fulfillment. Handling costs included in operating expenses — fulfillment for the fiscal years ended March 28, 2004, March 30, 2003 and March 31, 2002 were $4.7 million, $3.8 million and $2.8 million, respectively. Our gross profit may not be comparable to other entities, which may allocate all shipping and handling costs to either cost of sales, resulting in lower gross profit, or operating expenses, resulting in higher gross profit.

      Inventory. Inventories, net of an allowance for excess quantities and obsolescence, are stated at the lower of cost or market. We estimate a provision for damaged, obsolete, excess and slow-moving inventory based on inventory aging reports and specific identification. If actual obsolescence is different from our estimate, we will adjust our provision accordingly. Specific reserves are recorded in the event the cost of the inventory exceeds the fair market value. In addition, we estimate a reserve for expected inventory shrinkage based on historical shrinkage factors and our current inventory levels. Actual shrinkage is recorded at year-end based on the results of our physical inventory count. For the fiscal years ended March 28, 2004, March 30, 2003, and March 31, 2002, we wrote down inventory of approximately $0.3 million, $0.6 million, and $0.4 million, respectively.

      Accounting for income taxes. Significant management judgment is required in determining our deferred tax assets and liabilities and any valuation allowance recorded against our net deferred tax assets. As of March 28, 2004, we had recorded a valuation allowance of $28.0 million against our net deferred tax asset balance due to uncertainties related to our deferred tax assets as a result of our history of operating losses. The valuation allowance is based on our estimates of taxable income by jurisdiction in which we operate and the period over which our deferred tax assets will be recoverable. In the event that actual results differ from these estimates or we adjust these estimates in future periods, we may need to change the valuation allowance, which could materially impact our financial position and results of operations.

      Catalog Amortization. Prepaid catalog costs consist of third-party costs including paper, printing, postage and mailing costs for all of our direct response catalogs. Such costs are capitalized as prepaid catalog

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      Valuation of long-lived assets. Long-lived assets held and used by us are reviewed for impairment whenever events or changes in circumstances indicate the net book value may not be recoverable. An impairment loss is recognized if the sum of the expected future cash flows from use of the asset is less than the net book value of the asset. The amount of the impairment loss will generally be measured as the difference between net book values of the assets and their estimated fair values. Our estimate of undiscounted future cash flows is based upon our experience, historical operations, estimates of future profitability and economic conditions. During fiscal 2002, we recorded a $1.2 million impairment charge related to certain software related to our website that was no longer being utilized due to system enhancements completed during fiscal 2002.

      Stock based compensation. We account for stock options granted to employees using the intrinsic value method in accordance with Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees.” Accordingly, no compensation expense has been recognized in the financial statements for stock options. SFAS No. 123, “Accounting for Stock-Based Compensation,” as amended by SFAS No. 148, “Accounting for Stock-Based Compensation — Transition and Disclosure,” however, requires the disclosure of pro forma net earnings and earnings per share as if we had adopted the fair value method. Under SFAS No. 123, the fair value of stock-based awards to employees is calculated through the use of option pricing models. These models require subjective assumptions, including future stock price volatility and expected time to exercise, which affect the calculated values. Our calculations are based on a single option valuation approach and forfeitures are recognized as they occur.

      In fiscal 2000, we granted approximately 0.4 million options to employees at an exercise price that was less than the fair market value of our stock on the date of grant. We recorded $1.8 million of deferred compensation related to these option grants, which is included as a separate component of stockholders’ equity, and is being amortized over the vesting period of the awards. We recorded amortization expense of $132,000, $359,000, and $406,000 in fiscal 2004, 2003, and 2002, respectively, which is included in general and administrative expenses in the statements of operations.

      In fiscal 2004, we granted approximately 0.3 million options to employees at an exercise price that was less than the fair market value of our stock on the date of grant. We recorded $0.7 million of deferred compensation related to these option grants, which is included as a separate component of stockholders’ equity, and is being amortized over the vesting period of the awards. We recorded amortization expense of $130,000 in fiscal 2004, which is included in general and administrative expenses in the statements of operations.

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Results of Operations

      The following table sets forth our statements of operations data expressed as a percentage of net revenues. Our fiscal year is based on a 52 or 53-week year. The fiscal year ends on the Sunday closest to March 31.

Comparison of Years Ended March 28, 2004 with March 30, 2003

Net Revenues

      Our net revenues are comprised of product sales, shipping revenue and gift-wrap revenue. Revenues are recorded net of estimated returns, coupons redeemed by customers, and other discounts. Our shipping revenue represents the amounts we charge our customers for delivering the product. Our gift wrap revenue consists of amounts we charge our customers for our signature red gift boxes.

      Net revenues were $79.3 million and $70.1 million for fiscal 2004 and 2003, respectively, representing a 13.2% increase. The increase was primarily due to increased demand for our products resulting from additional marketing efforts through our online and catalog campaigns. During fiscal 2004, we increased our online marketing programs compared to the prior year. Online revenues, through search, portals, and affiliates, grew 44% over the prior year. Revenues from customers who receive our catalogs, grew 9% over the prior year. In the first quarter of fiscal 2004, we introduced a catalog dedicated solely to jewelry products. Also, in the second quarter of fiscal 2004, we introduced a new catalog that featured non-seasonal gifts for all occasions. For the third quarter of fiscal 2004, our Holiday catalog circulation decreased by approximately 2.0 million catalogs, or 21.7%, from the same period in the prior year. For fiscal 2004, we circulated approximately the same number of catalogs as the prior fiscal year. The number of orders increased approximately 12.2% over fiscal 2003. Net revenues per order decreased by approximately 0.9% over fiscal 2003. This was primarily attributable to lower shipping revenues for the third and fourth quarters of fiscal 2004 in comparison to the third and fourth quarters of fiscal 2003. As of March 28, 2004, we had approximately 1.8 million customers which was an increase of 0.5 million customers over fiscal 2003.

      From the second quarter of fiscal 2003 until August 25, 2003, the delivery charge to our customers was based on the order value and the method of delivery. As the order value increased, the delivery charge increased as well. In August of 2003, we changed the delivery charge for standard ground delivery to a flat rate regardless of order value. For expedited delivery methods, we charge a flat fee over the standard delivery charge. Periodically, we offer shipping discount promotions intended to increase order volume. The change to

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Cost of Sales

      Cost of sales consists of the cost of the product sold, inbound and outbound freight costs and gift-wrap expense. Shipping costs, which include inbound and outbound freight costs, and the cost of gift wrap are included in cost of sales. Handling costs, which include fees paid to our former third-party fulfillment service provider and distribution center expenses, are included in operating expenses — fulfillment.

      Cost of sales were $39.6 million and $36.6 million for fiscal 2004 and 2003, respectively, representing 49.9% and 52.2% of net revenues, respectively. The 8.2% increase in cost of sales was mainly attributable to the 13.2% increase in net revenues as well as additional shipping costs incurred during December 2003. During December 2003, we expedited delivery of certain orders due to delays in the fulfillment process at our distribution center. The expedited delivery methods resulted in additional shipping costs above our expectations. The decrease in cost of sales as a percentage of net revenues was primarily attributable to higher average product margins resulting from an increase in overseas product sourcing, which typically have lower product costs. This was slightly offset, however, by higher shipping costs as a result of the aforementioned increase in expedited delivery. If we are unable to improve the performance of the fulfillment process at our distribution center, we may be required to expedite delivery of products which will result in additional shipping costs which would increase our cost of sales.

Operating Expenses

      Fulfillment. Fulfillment expenses consist of wages and benefits for employees and seasonal hires working in our distribution center and customer service facility, fees incurred to process credit card transactions and certain fixed costs, such as rent and utilities, incurred by our distribution center and customer service facility. Prior to August 2003, fulfillment expenses also included fees paid to our former third-party fulfillment service provider. Services performed by our former third-party fulfillment service provider included receiving, picking, packing, shipping and other warehousing activities.

      Fulfillment expenses were $12.2 million and $10.8 million for fiscal 2004 and 2003, respectively, representing in each year 15.4% of net revenues. The increase in dollars was primarily attributable to the 12.2% increase in the number of orders, specifically labor costs incurred at our distribution center during the third quarter of fiscal 2004. In addition, delays in the fulfillment process at our distribution center, required us to utilize more seasonal employees and incur more overtime hours than anticipated. To address the prior delays, we are in the process of revising certain materials handling processes, implementing new warehouse management software, and effecting management changes. We believe that these changes will allow us to better manage our fulfillment operations and scale our business. If we are unable to improve the performance of the fulfillment process at our distribution center or if our planned modifications cost more than we anticipate, our business and operating results could be materially harmed.

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

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      Marketing expenses were $16.7 million and $15.3 million for fiscal 2004 and 2003, respectively, representing 21.0% and 21.8% of net revenues, respectively. The increase in dollars was primarily due to the additional spending in our online marketing channels. In addition, we introduced television advertising, which led to additional interest in our products and catalogs. These increases were slightly offset by a decrease in our catalog expenses. While we circulated approximately the same number of catalogs as the prior fiscal year, we were able to achieve certain costs efficiencies related to paper and production. The cost efficiencies associated with our catalog business resulted in a slight decrease in our marketing expenses as a percentage of net revenues. Currently, we plan to consider marketing opportunities through television, radio, and print advertising to further enhance our brand. In addition, we currently plan on increasing the number of catalogs circulated. As of March 28, 2004, the number of existing customers had increased approximately 0.5 million from the end of fiscal 2003. We intend to increase the amount of catalog prospecting in fiscal 2005 compared to fiscal 2004. If we are unsuccessful in generating revenues through these marketing vehicles, our operating results could be adversely affected.

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

      General and administrative expenses were $15.7 million and $14.6 million for fiscal 2004 and 2003, respectively, representing 19.8% and 20.8% of net revenues, respectively. The increase in dollars was primarily due to severance costs related to former employees of $0.6 million and higher costs associated with being a public company. As a percentage of net revenues, the decrease was primarily due to similar costs allocated over a larger revenue base. As of March 28, 2004, we had a total of approximately $0.3 million in deferred compensation expense as a result of stock options issued in fiscal 2000 and fiscal 2004 at exercise prices that were less than the fair market value of our common stock at the time of grant. The amounts to be amortized are expected to be approximately $65,000 in each of the fiscal 2005-2008, less any cancellations or forfeitures of stock options subject to the deferred compensation. The planned implementation of new software systems in fiscal 2005 will result in additional depreciation expense. In addition, the regulatory requirements associated with being a public company will likely increase our accounting and legal expenses. We currently plan on slightly increasing our general employee headcount (i.e., employees other than fulfillment and customer service employees) in order to support future business needs, which will add to general and administrative expenses.

Other Income and Expenses

      Interest Income. Interest income was $0.2 million for each of fiscal 2004 and 2003.

      Interest Expense. Interest expense was $0.4 million and $0.7 million for fiscal 2004 and 2003, respectively. The decrease was attributable to lower amounts of debt outstanding.

      Income Taxes. As of March 28, 2004, we had $100.5 million of net operating loss carryforwards, which may be impaired or limited in certain circumstances. These net operating loss carryforwards will begin to expire in 2007. We have provided a valuation allowance on our deferred tax assets, consisting primarily of net operating loss carryforwards, because of the uncertainty regarding their realizability.

Comparison of Years Ended March 30, 2003 with March 31, 2002

Revenues

      During fiscal 2003, net revenues increased 25.6% from $55.8 million to $70.1 million relative to the prior year. This was primarily due to increased demand for our products resulting from additional marketing efforts through our catalog campaigns. During fiscal 2003, we increased our catalog circulation by approximately 3.6 million catalogs, or 23.3%. The number of orders increased approximately 17% and the revenue per order increased approximately 7%. Our customer base increased from approximately 853,000 to approximately 1.3 million. In addition, in the second quarter of fiscal 2003, we began to base our delivery charge on the order

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Cost of Sales

      Cost of sales were $36.6 million and $31.4 million for fiscal 2003 and 2002, respectively, representing 52.2% and 56.4% of net revenues, respectively. The increase in dollars was mainly attributable to the 25.6% increase in net revenues. The decrease in cost of sales as a percentage of net revenues in fiscal 2003 compared to fiscal 2002 was primarily a result of our improved cost leverage with vendors due to increased volumes of merchandise that we purchased and the sale of higher margin products on average.

Operating Expenses

      Fulfillment. Fulfillment expenses were $10.8 million and $9.0 million for fiscal 2003 and 2002, respectively. As a percentage of net revenues, fulfillment was 15.4% in fiscal 2003 and 16.2% in fiscal 2002. The increase in dollars was primarily attributable to the 17% increase in the number of orders. The cost to fulfill orders through our third party distribution center increased approximately $0.9 million. There was an increase of approximately $0.2 million in salaries at our customer service center for additional employees hired to accommodate the increase in sales transactions. Our credit card processing fees increased approximately $0.3 million due to the increase in revenues. In addition, rent and utilities at our third party distribution center and our customer service facility increased approximately $0.4 million. The decrease in fulfillment expenses as a percentage of net revenues was primarily attributable to economies of scale achieved through an increased number of sales transactions and higher average order value.

      Marketing. Marketing expenses were $15.3 million and $13.4 million for fiscal 2004 and 2003, respectively As a percentage of net revenues, marketing expenses were 21.8% in fiscal 2003 and 24.0% in fiscal 2002. The increase in dollars was primarily due to the increase in catalog circulation. We mailed approximately 15.1 million catalogs in fiscal 2002 and 18.7 million in fiscal 2003. As a result, costs for catalog printing, postage and lists increased approximately $2.4 million. This increase was partially offset by decreases in spending related to online marketing programs of approximately $0.6 million.

      General and Administrative. General and administrative expenses were $14.6 million and $15.4 million for fiscal 2003 and 2002, respectively. As a percentage of net revenues, general and administrative expenses were 20.8% in fiscal 2003 and 27.7% in fiscal 2002. The decreases were primarily due to an impairment charge of approximately $1.2 million incurred in fiscal 2002, as well as reductions in bonuses, travel, depreciation and recruiting costs of approximately $0.8 million. These decreases were offset in part by increases in salaries of approximately $1.0 million due to additional employees hired and severance paid to former employees. During fiscal 2002, due to system enhancements completed during fiscal 2002, the Company determined that certain software related to our website was no longer being utilized. As a result, the Company identified $1.2 million of unamortized costs associated with the unused software and wrote off these costs during fiscal 2002.

Other Income and Expenses

      Interest Income. Interest income was $0.2 million and $0.5 million in fiscal 2003 and 2002, respectively. The decrease was primarily due to lower average interest rates earned in fiscal 2003.

      Interest Expense. Interest expense was $0.7 million and $1.0 million in fiscal 2003 and 2002, respectively. The decrease was primarily due to a reduction of approximately $4.8 million in our outstanding debt.

Liquidity and Capital Resources

      We have funded our operations through March 28, 2004 primarily through private sales of equity securities, borrowings, and the completion of our initial public offering which resulted in net offering proceeds of approximately $29.0 million. Historically, revenues have been seasonal. Revenues have been higher in the

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      Cash Flows From Operating Activities — Net cash flows used in operating activities was $0.7 million, $6.9 million and $11.5 million for fiscal 2004, 2003, and 2002, respectively. In fiscal 2004, net cash used in operating activities decreased by $6.1 million from fiscal 2003, resulting primarily from revenue growth of 13% and related higher gross profit, partially offset by higher operating expenses and by changes in working capital. Specifically, there was an increase in our accrued expenses and other current liabilities for accrued severance, shipping, legal, and salary expenses. Our merchandise inventories remained consistent with the prior fiscal year balance. This was primarily due to improved inventory management and slightly lower number of products compared to fiscal 2003. In fiscal 2003, net cash used in operating activities decreased by $4.6 million from fiscal 2002, resulting primarily from revenue growth of 26% and related higher gross profit, partially offset by higher operating expenses and by changes in working capital. Specifically, there was an increase in our merchandise inventories in anticipation of higher sales as well as our decision to maintain higher levels of inventory for core merchandise.

      Cash Flows From Investing Activities — Net cash flows (used in) provided by investing activities was ($11.3) million, ($1.5) million and $6.3 million for fiscal 2004, 2003, and 2002, respectively. Uses of cash flow for investing activities were for purchases of investments as well as capital expenditures for property and equipment. Currently, we are planning capital expenditures for software systems to support our financial, warehouse management, and order management functions. We believe the implementation of these software systems will support the needs of our business and customers. Software implementation projects entail significant technical and business risks. If we are unsuccessful in implementing these systems, it may hinder our ability to process and fulfill customer orders as well as complete critical financial processing transactions. These capital expenditures may result in an increase in our depreciation expense. We currently estimate spending between $1.2 million and $1.5 million over the next twelve months on the financial and warehouse management systems. In addition, we are considering projects for an order management system and other warehouse upgrades which we estimate may range between $1.5 to $2.0 million. Although we believe these estimates on expenditures to be reasonable given the current facts and circumstances available to us, we can offer no assurance that the actual amounts expended will not be greater.

      Cash Flows From Financing Activities — Net cash flows provided by (used in) financing activities were $25.4 million, $8.5 million and ($1.2) million for fiscal years 2004, 2003, and 2002, respectively. For fiscal 2004, net cash provided by financing activities consisted of the net proceeds from our initial public offering whereby we sold 2.2 million shares of our common stock at $14 per share and received proceeds of approximately $29.0 million (after underwriter’s discount of $1.8 million) slightly offset by payments on an existing line of credit as well as a $1.1 million repayment of a loan, plus our initial public offering related expenses of approximately $1.5 million. For fiscal 2003, net cash provided by financing activities consisted primarily of approximately $13.6 million of net proceeds from the issuance of Series F convertible preferred stock slightly offset by a $4.8 million repayment of a loan. For fiscal 2002, cash used in financing activities consisted of payments of $1.2 million on an outstanding working capital line of credit and capital lease obligations.

      Revolving Credit Facility — We also have funds available of up to $11 million pursuant to its revolving credit facility with CapitalSource Finance LLC, which is described more fully in Note 6 to the financial statements contained in this report. Our ability to borrow under this credit facility is subject to compliance with its terms. As of March 28, 2004, we were not in compliance with the EBITDA, Inventory Ratio, and Change in Control covenants contained in the credit agreement and such breach constituted an event of default under the credit agreement, and we have failed to comply with such covenants in prior months during the term of the credit facility. On April 29, 2004, CapitalSource Finance LLC agreed to waive such non-compliance with such covenants which was designated as the First Amendment to the credit facility

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      On June 21, 2004, the Company amended the terms of its credit facility with CapitalSource Finance LLC. Under the terms of this Second Amendment, certain covenants for inventory ratios and capital expenditure limitations were eliminated. The minimum earnings before interest, taxes, depreciation and amortization (EBITDA) covenant was modified, and quarterly minimum unrestricted cash balance levels were established. Further, under this Second Amendment, the EBITDA and minimum unrestricted cash balance covenants were modified such that they are not applicable unless borrowings are outstanding.

      In advance of any borrowings, the Company is required to deliver to CapitalSource Finance LLC written notification of its intent to borrow, certain consents from the Company’s landlords and credit card processing firm, a list of domain name registrations, evidence of compliance with EBITDA and minimum unrestricted cash balance levels on a prospective basis, and historical and prospective financial statements. In addition, CapitalSource Finance LLC may perform due diligence on the Company’s financial projections.

      We believe that the cash currently on hand will be sufficient to continue operations through at least the next twelve months. Our assessment is based on historical working capital needs, operating loss trends, and current business outlook. Beyond the next twelve months, we intend to utilize the cash generated from operations to fund operations and capital expenditures. Additionally, equity and or debt financing may need to be obtained to support our long-term obligations and needs. However, there can be no assurance that if additional financing is necessary it will be available, or if available, that such financing can be obtained on satisfactory terms or without undue dilution to, or an adverse impact on the rights of, our existing stockholders. Failure to generate sufficient revenues or raise additional capital could have a material adverse effect on our ability to continue as a going concern and to achieve our intended business objectives.

Contractual Obligations

      The following table summarizes significant contractual obligations as of March 28, 2004:

      Capital Leases — Our $1.6 million of capital lease obligations consist primarily of equipment used at our fulfillment center. The terms of these leases extends into our fiscal year 2007. At the end of the lease term, we have the option to purchase the equipment for $1.

      Operating Leases — At March 28, 2004, we had operating lease obligations of approximately $2.1 million. Our operating lease obligations primarily consist of payments related to properties that we occupy for our headquarters, customer service center and fulfillment center. The lease terms expire in September 2004, March 2005, and July 2006, respectively. We are currently negotiating a lease for new headquarters space in San Francisco, California, but there are no assurances these negotiations will be successful.

      Purchase Obligations — Amounts represent estimated commitments at March 28, 2004 to purchase inventory and other goods and services in the normal course of business to meet operational requirements. These obligations are expected to be paid in future periods as stated in the table.

      Other Contractual Arrangements — In our normal course of business, we are party to a variety of contractual agreements under which we may be obligated to indemnify the other party for certain matters. These contracts primarily relate to our commercial partnerships, supply agreements, operating leases, license agreements, financial agreements and various other agreements. Under these contracts, we may provide

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Commercial Commitments

      The following table provides summary information concerning our outstanding commercial commitments as of March 28, 2004:

      Revolving Credit Facility — We have available up to $11 million pursuant to its revolving credit facility with CapitalSource Finance LLC, which is described more fully in Note 6 to the financial statements contained in this report. Our ability to borrow under this credit facility is subject to compliance with its terms. As of March 28, 2004, we were not in compliance with the EBITDA, Inventory Ratio, and Change in Control covenants contained in the credit agreement and such breach constituted an event of default under the credit agreement. On April 29, 2004, CapitalSource Finance LLC agreed to waive such non-compliance with such covenants which was designated as the First Amendment to the credit facility agreement. We are currently able to draw down funds under this credit facility. At March 28, 2004, we had no borrowings under the revolving credit facility.

      On June 21, 2004, the Company amended the terms of its credit facility with CapitalSource Finance LLC. Under the terms of this Second Amendment, certain covenants for inventory ratios and capital expenditure limitations were eliminated. The minimum earnings before interest, taxes, depreciation and amortization (EBITDA) covenant was modified, and quarterly minimum unrestricted cash balance levels were established. Further, under this Second Amendment, the EBITDA and minimum unrestricted cash balance covenants were modified such that they are not applicable unless borrowings are outstanding.

      In advance of any borrowings, the Company is required to deliver to CapitalSource Finance LLC written notification of its intent to borrow, certain consents from the Company’s landlords and credit card processing firm, a list of domain name registrations, evidence of compliance with EBITDA and minimum unrestricted cash balance levels on a prospective basis, and historical and prospective financial statements. In addition, CapitalSource Finance LLC may perform due diligence on the Company’s financial projections.

      Letters of Credit — We have letters of credit outstanding associated with our headquarters office space in San Francisco and a marketing agreement. Both letters of credit will expire in fiscal 2005 and are classified as restricted cash on the balance sheets of our financial statements.

Recently Issued Accounting Standards

      In January 2003, the FASB (Financial Accounting Standards Board) issued FASB Interpretation No. 46, Consolidation of Variable Interest Entities, an interpretation of ARB No. 51 (“FIN 46”). FIN 46 requires certain variable interest entities to be consolidated by the primary beneficiary of the entity under certain conditions. The Company does not have any involvement in variable interest entities. The adoption of FIN 46 did not have a material impact on the Company’s results of operations, financial position or cash flows.

      In May 2003, the FASB issued SFAS No. 150, “Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity.” SFAS No. 150 requires instruments that are mandatorily

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      Interest Rate Risk We currently maintain a portfolio of fixed and variable investments consisting of cash equivalents, short-term marketable securities and long-term marketable securities, which can be affected by changes in market interest rates. The objective of our investment activities is to preserve principal, while at the same time maximizing yields without significantly increasing risk. To achieve this objective, we invest in highly liquid, investment grade and government debt securities. Our investments in debt securities are subject to interest rate risk. According to our investment policy, we may invest in taxable and tax exempt instruments. In addition, the policy establishes limits on credit quality, maturity, issuer and type of instrument. Marketable securities are classified as “available for sale”. Marketable securities are comprised of government securities and corporate bonds. We do not use derivative financial instruments in our investment portfolio. (See Note 3 of Notes to Financial Statements)

      All highly liquid investments with maturity of three months or less at the date of purchase are considered to be cash equivalents. The remaining investments in marketable securities are considered short-term investments if original maturities range over three months but less than one year, or long term investments if original maturities are one year or longer.

      The following table lists our cash and cash equivalents, short-term investments and long-term investments at March 28, 2004:

      If interest rates changed adversely by 100 basis points, our results from operations and cash flows would not be materially affected.

      Foreign Currency Risk We purchase a significant amount of inventory from vendors outside of the U.S. in transactions that are denominated in U.S. dollars. As of March 28, 2004, any currency risks related to these transactions were not significant to us. A decline in the relative value of the U.S. dollar to other foreign currencies could, however, lead to increased purchasing costs.

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REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

To the Board of Directors and Stockholders of
RedEnvelope, Inc.

We have audited the accompanying balance sheets of RedEnvelope, Inc. as of March 28, 2004 and March 30, 2003 and the related statements of operations, stockholders’ equity/(deficit) and comprehensive loss, and cash flows for each of the three years in the period ended March 28, 2004. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.

We conducted our audits in accordance with standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

In our opinion, such financial statements present fairly, in all material respects, the financial position of RedEnvelope, Inc. as of March 28, 2004 and March 30, 2003 and the results of its operations and its cash flows for each of the three years in the period ended March 28, 2004, in conformity with accounting principles generally accepted in the United States of America.

/s/ DELOITTE & TOUCHE LLP

San Francisco, California

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RedEnvelope, Inc.

BALANCE SHEETS

See accompanying notes to these financial statements.

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RedEnvelope, Inc.

STATEMENTS OF OPERATIONS

See accompanying notes to these financial statements.

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REDENVELOPE, INC.

STATEMENTS OF STOCKHOLDERS’ EQUITY/(DEFICIT) AND COMPREHENSIVE LOSS