GSI Commerce, Inc. F3Q08 (Quarter End 9/27/08) Earnings Call Transcript

GSI Commerce, Inc. (GSIC)

F3Q08 Earnings Call

October 22, 2008 4:45 pm ET

Executives

Michael R. Conn - Chief Financial Officer, Executive Vice President - Finance

Michael G. Rubin - Chairman of the Board, President, Chief Executive Officer

Analysts

Mark May - Needham & Co.

Jennifer Watson - Goldman Sachs

Sandeep Aggarwal - Collins Stewart

Christa Sober Quarles - Thomas Weisel Partners

Nat Schindler - Merrill Lynch

Shyam Patil - Raymond James & Associates

Sameet Sinha - JMP Securities

Ross MacMillan - Jefferies & Company

Analyst for Jim Friedland - Cowen and Company

Analyst for Brian J. Pitz - Bank of America Securities

Herman Leung - Deutsche Bank Securities

Sebastian – Lazard Capital Markets

Atul Bagga – Thinkpanmure, LLC

Presentation

Operator

Welcome to the third quarter 2008 GSI Commerce, Inc. operating results conference call. My name is Kim and I’ll be your coordinator for today. At this time all participants are in listen-only mode. We will be facilitating a question and answer session towards the end of today’s conference. (Operator Instructions)

I would now like to turn the presentation over to your host for today’s conference Mr. Michael Conn, GSI’s Chief Financial Officer.

Michael R. Conn

This is Michael Conn, CFO of GSI Commerce, and I am jointed by Michael Rubin, our Chairman and CEO.

Before we get into the results, I would like to make the following remarks concerning forward-looking statements. All statements in this conference call other than historical facts are forward-looking statements. The words anticipate, believe, estimate, expect, intend, will, guidance, confident and similar expressions typically are used to identify forward-looking statements. These forward-looking statements are based on current expectations, beliefs, assumptions, estimates and forecasts about the business of GSI Commerce. These statements are not guarantees of future performance and involve risks, uncertainties and assumptions which are difficult to predict. Therefore actual outcomes and results may differ materially from what is expressed or implied by these forward-looking statements. Factors that may affect GSI’s business, financial condition and operating results are discussed in its filings with the SEC. GSI Commerce expressly disclaims any intent or obligation to update these forward-looking statements.

During this call we also will present certain non-GAAP financial measures; non-GAAP net revenues, non-GAAP income from operations and free cash flow and certain ratios that use these measures. In our Form 8K which is located on our website at www.gsicommerce.com under SEC Filings you will find our definition of these non-GAAP financial measures, a reconciliation of these non-GAAP financial measures with the closest GAAP measures and a discussion about why we think these non-GAAP measures are relevant. These financial measures are included for the benefit of investors and should be considered in addition to and not instead of GAAP measures.

Now I’ll provide an overview of our results and an update of our business and outlook. Michael and I will then take questions.

We delivered very good results in the third quarter. Our revenue growth remains strong with net revenues increasing 36% and non-GAAP revenues increasing 66%. Net revenues were a little bit below our guidance range primarily due to lower than expected product sales. Nevertheless, through strong operating efficiencies and careful attention to fixed costs we were still able to exceed the high end of our previously issued guidance for loss from operations and non-GAAP income from operations by $2 million and $1.3 million respectively.

We achieved excellent results in the first nine months of the year and believe we are on track to achieve our bottom line guidance for the full year. Recently we have faced some revenue challenges specific to certain clients notably the erosion of business from Linens-N-Things which had been a Top 10 client for us. Yet we continue to see strong growth from a broad cross section of our clients and we are confident that we have the levers in our business to react to a dynamic environment and position ourselves to deliver good results.

Looking beyond the fourth quarter, we look forward to 2009. Our new business and client renewal pipelines are strong. Ecommerce is projected to continue growing at a faster rate than overall retail and interactive marketing services are expected to gain share from traditional marketing channels. The acquisitions of accretive commerce Zendor and e-Dialog are all performing well and we are excited by our recently announced pending acquisition of Innotrac.

In addition we are focused on managing expenses.

I’ll now cover the third quarter results in more detail and then I’ll add some color to our outlook and business update including commentary on the pending Innotrac acquisition.

For the third quarter net revenue increased 36% to $186.8 million from $137.3 million and non-GAAP net revenue increased 66% to $102.3 million from $61.7 million. Product sales increased 12% and service fees increased 84%. This reflects the continued shift of our business away from owned inventory.

Growth in ecommerce transactions for sites operated for the entirety of both periods was again better than the 8% to 10% growth rate reported for the ecommerce industry. In what is the top retail environment we are focused on driving revenues including working closely with our clients to help them maximize their business.

Within product sales we saw strong results from our professional sports league business, mixed results from general sporting goods, and weakness in electronics. Service fee growth was driven by contribution from the three acquisitions made since mid-2007, strong comparable store revenue and strong organic growth in marketing services. Service fees represented 45% of net revenues in the quarter. Strong ecommerce service fee categories included apparel, toys and baby, health and beauty, and jewelry.

Cost of product sales increased 12% which was in line with the growth in product sales and roughly flat product margins.

Marketing expenses increased 10% to $11.4 million from $10.3 million and were also roughly flat with last year as a percentage of product sales at 11.2%.

Account management and operations increased 59% to $58.7 million from $37 million. This compared to growth of 82% in the second quarter and reflects the affected moderating growth trend as we anniversaried the full operation of our automated fulfillment center in Richwood as well as eliminating costs related to the specialty food client we exited in the second quarter.

Similar to recent quarters the biggest driver of increased expenses in the line item was expenses related to the three acquisitions.

Product development expenses increased 62% to $25.7 million from $15.9 million but were up only $552,000 sequentially. The largest driver of year-over-year increased product development expenses was expenses associated with acquired companies.

General and administrative expenses increased 56% in the quarter to $17.5 million from $11.2 million but were down sequentially in actual dollars from the second quarter. Once again acquisitions were the biggest driver of the year-over-year increase in this expense line.

Non-GAAP income from operations was $5.8 million compared to a loss of $200,000 last year and above the high end of our guidance range of $3.5 million to $4.5 million. Year-to-date non-GAAP income from operations of $13.2 million is up 208% from $4.3 million last year.

Turning to our balance sheet, cash and cash equivalents of $45.1 million was down $4.5 million sequentially reflecting the normal seasonality of our business and also declined from a year ago due to the acquisitions of e-Dialog and Zendor which occurred after the end of the third quarter 2007.

Inventory increased only 2% year-over-year despite 12% growth in product sales reflecting solid improvement in inventory turns.

Free cash flow on a trailing 12 month basis decreased from approximately break-even to -$8.4 million. The primary driver of the decrease was timing of capital expenditures and working capital. We expect to generate positive free cash flow for fiscal 2008.

Now for some business highlights. New client additions remained strong during the quarter with one of the four deals that were noted to be in contract last quarter converting into a new client. We signed a multiyear ecommerce agreement with Big Lots, the largest broad line closeout retailer in the US with trailing 12 month revenues of $4.7 billion. Earlier this week we launched the first online business. GSI’s providing ecommerce technology, fulfillment and customer care for Big Lots new ecommerce offering which features a deal of the day format. We believe this has good potential as we have seen other companies enjoy success with a deal of the day format.

In addition to the Big Lots launch, we launched Web Source for Calvin Klein’s enterprise business here in the US and also rolled out multiple international store launches for the casual male and Rochester big and tall brands. We also launched customer service operations for [Belk] department stores and launched a new web store for one of our largest apparel clients for one of their brand extensions. I would add that the pipeline remains strong and we expect additional new client wins prior to year end.

We also signed two very important client renewals during the quarter: Dick’s Sporting Goods and Aeropostale. Our new agreement with Dick’s Sporting Goods runs through 2024 and strengthens our ecommerce partnership longer term for both companies while enabling Dick’s to gain greater control by taking on the buying and merchandising responsibility, something that GSI had previously done in expanding their multichannel integration for the planned rollout of in-store pickup and in-store ordering.

We also enhanced the suite of services GSI provides to Dick’s with an agency of record designation for marketing services as well as the renewal of their agreement with e-Dialog. Since becoming a client in 2001 we’ve helped Dick’s Sporting Goods grow their online business significantly and we look forward to continued growth going forward.

Our extension with Aeropostale runs through 2018 and reflects the growth and success we’ve had with this client since 2005. We will continue to provide Aeropostale with a full service integrated ecommerce solution while also expanding our relationship with them for interactive marketing services that include usability, design, product photography and email services.

Our marketing services segment performed well during the quarter with a 225% growth in net revenues to $23.1 million from $7.1 million fueled by the acquisition of e-Dialog and organic growth in GSI interactive. Segment operating profits were $3.1 million compared to $1.3 million last year.

GSI interactive had a strong quarter. In addition to Aeropostale the agency signed additional business with several clients including Ace Hardware, Sports Authority, Christopher and Banks, and PBS for services that included search marketing, usability research, site design, studio photography and managing email marketing using e-Dialog’s products. On the e-Dialog side the company signed new email marketing deals with several new clients including Sony Go View, Razor Gator, and Figi’s Gifts and Good Taste.

We expect continued strength from our marketing services segment in the fourth quarter and beyond. Even in the current environment where some companies are cutting their overall marketing budgets we believe that spending on ROI based marketing particularly email but also paid search and affiliate should be less impacted than other types of marketing because of their proven value. As we have said previously, email historically has had the highest ROI compared to any other marketing channel according to the Direct Marketing Association.

Now let me discuss the recently signed definitive agreement to acquire Innotrac Corporation. Strategically and financially we believe this is a very good deal for GSI as it furthers our leadership position in ecommerce and multichannel services by bringing new clients, enhancing our scale for fulfillment and call center services, and adding to our available capacity to support the growth of new and existing clients. Innotrac’s clients include Target, Ann Taylor, Smith & Hawkin, The North Face, Kay Jewelers, L’Oreal, Scholastic, Delivery Agent, Motorola, Microsoft and Qwest.

A little over a year ago we acquired Accretive Commerce with a similar rationale and that deal is proving to be very beneficial to GSI. We expect similar revenue and profit contribution from Innotrac as we did from Accretive though with the added benefit of a lower purchase price and more excess capacity. Following the close of the acquisition we will operate approximately 4.7 million square feet of fulfillment centers and 2,165 call center seats giving us what we believe is one of the most significant b-to-c fulfillment and call center infrastructures in the US.

We are also excited about Innotrac’s Western US facility in Reno, Nevada which we intend to use to begin offering regional fulfillment capabilities to clients in 2009.

Financially we believe the deal will have a positive impact to us in 2009 both in terms of non-GAAP income from operations per share and free cash flow per share. For the trailing 12 months ending June 30, 2008 Innotrac recorded net revenues of $128.2 million, income from operations of $4.5 million and non-GAAP income from operations of $8.9 million. It is worth noting that Innotrac previously announced that these results included contribution from a significant client from the telecommunications category whose fulfillment contract will expire in the middle of 2009 and is not expected to renew.

So our new 2008 full year results is a proxy for Innotrac’s base earnings. However they have a solid base of continuing clients with good growth trends and there are some nice synergies in the deal. Also, when evaluating the approximately $62 million aggregate value of the deal, I think it is worth noting that Innotrac has gross property and equipment of $49.9 million and net property and equipment of $17 million which we view as representative of hidden asset value.

Turning to our guidance, for the full year we are reiterating guidance of non-GAAP income from operations of $80 million to $83 million and loss from operations of $6.5 million to $9.5 million as expense management and our focus on operating efficiency should offset modestly reduced revenue expectations. We now expect net revenue for the year in the range of $950 million to $985 million versus previous expectations of approximately $1 billion reflecting our expectation for the impact from softer consumer spending trends as well as reduced revenues from Linens-N-Things.

Prior to Linens-N-Things finalizing their liquidation plan, we had already significantly reduced our internal plan for them through the remainder of this year and had already planned for them to no longer be a client after this year. The recent finalization of their liquidation plan includes our maintaining their ecommerce business throughout their going out of business sale, which we believe will enable us to mitigate the downside impact from their exit in the fourth quarter.

As we’ve noted, this type of event will happen on occasion to services companies that serve a broad base of clients. We feel good about our ability to absorb it based on our large and diverse client base. I’d also note that with their liquidation and the Innotrac acquisition we are well positioned with growth capacity already included in our overhead structure and this should ease our capital expense burden in the near term.

While we are experiencing some modest revenue headwinds in the fourth quarter albeit with still solid growth, we are paying careful attention to expenses including hiring more slowly, increasing our scrutiny of discretionary projects and increasing our focus on effective procurement. This is a process we started earlier in the year that is working well for us and something that we will continue to stay vigilant about. As a growth company, we have a lot of opportunities on the cost side and the reality is that we have found that tightening our belts is actually helping make us a better company.

Before turning the call over to questions, I wanted to reflect for a moment on what we believe has been a transformational 12 months for the company and also to discuss how we size up the impact of the current economic environment on GSI. As we look back in the last 12 months we see a business that has performed very well with good momentum in ecommerce transactions and new business wins and meaningful improvement in non-GAAP income from operations.

At the same time we have significantly improved our long-term runway with several large important client renewals including Aeropostale, Dick’s Sporting Goods and Ralph Lauren during the last two quarters. These three renewals which range from five to 15 years our three of our eight largest clients measured by year-to-date non-GAAP revenue and in all cases are with clients that invested meaningful time and energy evaluating their long-term options including in some cases with external assistance before deciding that the best outcome was to commit to GSI for the long term.

This is a great validation of the value we provide and a great reminder of the predictable revenue streams we enjoy as a business. While these are some of our largest clients, it is also worthwhile to remember that we remain a diversified business with no single client projected to account for more than 7% of non-GAAP net revenues in 2009. Dick’s Sporting Goods deal was also notable because it is shifting that relationship away from owned inventory to a non-owned inventory deal. This reflects the continuing transformation of the company to a technology and business services organization.

Finally, through a combination of the acquisition of e-Dialog and organic growth of GSI interactive, we have truly established marketing services as a pillar of our company and an important growth opportunity. We believe the current marketing services business could reach close to 25% of non-GAAP net revenue by 2011 and with additional acquisitions in this area possible potentially higher. We’re also encouraged by the success we are having with cross selling marketing services to existing ecommerce service clients including as part of ecommerce deal renewals.

We are obviously mindful of the current business environment. Certainly like every company this creates challenges for us but at the same time it also opens up opportunities. We expect that consumer spending is likely to be softer at least in the near term. However we remain fortunate that the growth of ecommerce continues to outpace retail and our specific group of multichannel customers has trended better than overall ecommerce.

I would reiterate what we said last call when we noted that ecommerce represents a small percentage of sales for our clients and we believe they will continue to experience share shift from offline to online and that interactive marketing still represents a small portion of our clients’ advertising spend. We believe they will continue to shift marketing dollars from offline onto online. We think in both cases even in an overall tougher environment the share shift trend is prevailing.

It is also important to note that as a company we’ve been biased towards investment and in good times we have spent aggressively to build growth capacity and opportunities. This should allow us room in the current environment to focus on expenses as we’ve done year-to-date and enable us to be positioned to achieve our non-GAAP income from operations and free cash flow goals for this year and next with operating metrics still representative of a growth company although obviously less than what they would be if the economy were stronger.

We also believe that as a strong company within our industry we are well positioned in the current environment and we would expect to see smaller and less established companies find it tougher to obtain financing and new business, and in some cases they may find themselves fighting for survival. We have already started to see some of this surfacing. Now more than ever companies are focused on partnering with strong established service providers. In addition we expect M&A multiples to moderate as we saw with our pending deal with Innotrac and we would expect to see good opportunities as we move forward.

Finally, we believe the outsourced value proposition is stronger in tough times and we are seeing that in our new business and renewal pipelines. Clearly given the current retail environment, companies are more capital constrained and more inclined to see the benefit of GSI’s expertise, capacity and scale.

With that we’ll turn the call over to questions.

Question-and-Answer Session

Operator

(Operator Instructions) Our first question comes from Mark May - Needham & Co.

Mark May - Needham & Co.

I have three really quick questions. First, have you seen any change in your new client pipeline activity given the economic environment? Secondly, revenues were not surprisingly a bit soft but you only mentioned electronics and Linens-N-Things as areas of softness. What other categories or customers also came in below expectations? And third, you mentioned that you did better than 8% to 10% same customer growth in Q3. What is your fourth quarter guidance imply on that same basis?

Michael G. Rubin

I’ll answer the first question and Michael Conn will answer the second and third questions. As far as the client pipeline goes, I’d say that it’s been very strong but I think in a difficult overall economic climate I think that value proposition’s even stronger. I certainly wouldn’t want to be in the business of selling software, looking to get big capital expenditures out of companies right now.

I think that’s something that we definitely hear in the environment is something that companies are looking to do first; the idea of outsourcing on a variable basis. I think that value proposition is as strong as it’s ever been. Certainly it’s been good but I think there’s been even more interest because of the environment. We definitely feel really good about our ability to accomplish our goals for 2008 and again I think the environment will only help from an overall pipeline perspective.

Michel R. Conn

As far as what we saw in terms of revenue trends, it was more strength than weakness and is really a continuation of what we’ve seen from a year-to-date perspective. Electronics had been hurting us. That didn’t change in the quarter. Even as that business has shrunk, the year-over-year declines are large enough that it’s still noteworthy to us. Linens-N-Things certainly was another hit for us that emerged last quarter; something that we mentioned last call was reflected in our guidance but it certainly eroded fairly quickly as a dynamic situation with them. So that was something that was new.

Besides that, normal ups and downs. Lots of areas of strength across a lot of categories. Nothing else that really stands out.

Mark May - Needham & Co.

Can you maybe quantify the hit from electronics and Linens-N-Things to top line growth or net revenue growth?

Michael R. Conn

If you look at our overall revenue growth in the quarter, obviously acquisitions had an impact. So if you just strip out acquisitions both on a non-GAAP net revenue as well as net revenue basis, it’s about 1/3 organic and 2/3 non-organic growth. The impact from the electronics partners as well as Linens-N-Things on the organic side of that was more than 500 basis points, so very significant within those two. It’s a big drag that really causes the overall growth trends to be understated.

At the same time as we’ve said, we’ll have ups and downs in the business so we don’t want to say that this isn’t the type of thing that will happen over time. The current environment means you might get hit with more of that but certainly it really does mask what is besides that pretty good underlying growth with the existing partners. If you look at the non-GAAP net revenue even with that, you had over 20% organic growth and without that you would have been significantly higher.

Your last question on comp store sales relative to industry growth trends which we cited in 8% to 10%. We were significantly above that in the third quarter although a little bit less than what we did in the second quarter. Our fourth quarter outlook calls for some continued moderation but still above those levels and good strong comp store growth.

Operator

Our next question comes from Jennifer Watson - Goldman Sachs.

Jennifer Watson - Goldman Sachs

Can you comment a little bit about the linearity of the quarter? Did you see any changes in consumer spending habits towards the second half of September, and if you can comment a little bit on what you’ve seen in the first couple weeks of October?

Michael R. Conn

We definitely noticed an impact in September so I would say July and August were both strong. Interestingly on a comp basis for us August was actually a little bit stronger than July. September was weaker than the first two although still a good comp number but definitely slowed down. I think as you suggest it slowed down in the back half of the month, and then we saw that carry forward into October.

For us our fiscal quarter ended September 27 so the first week of October for us was really the end of September into the early part of October. That was actually a fairly weak week for us. We saw a real dip there.

I think a couple of things of note were obviously just that was really at the height of just the real bad headlines with respect to what was going on in the financial markets. Also I think during that period of time, less noteworthy but something that we’re hearing from a number of our clients is just it was also unusually warm weather. I think that’s had an impact in certain categories, particularly apparel.

What we’ve seen since October’s progressed is actually encouraging because each progressive week we’ve seen a pickup in comp store sales. So the second week of the month was better than the first week, the third week was better than the second week, and we’re seeing good strength carrying into this week as well. We’re encouraged by the trend we’re seeing in October. We still obviously have a lot of the quarter in front of us but it seems like I’ve seen a softening and now a building trend again.

Jennifer Watson - Goldman Sachs

On the launch of casual male in Europe, can you talk a little bit about the strategy? I think you guys are outsourcing your fulfillment there. When do you think that you’ll have your own fulfillment centers in Europe outside of the UK and how does this affect your margins?

Michael R. Conn

There’s not a specific timetable. We continue to evaluate other opportunities within Europe for fulfillment and call center operations. We do see some opportunities out there. I think that we’re patient. We’re looking for the right ones. We continue to prefer acquisition of small businesses versus Greenfield building but we wouldn’t rule out the latter over time. But I think for now we’re happy to be doing the technology and the call center in-house. We’ve got a good partner for fulfillment and we’re pleased to have the stores live and kick off that relationship.

Operator

Our next question comes from Sandeep Aggarwal - Collins Stewart.

Sandeep Aggarwal - Collins Stewart

A couple of questions. One is, when you are seeing these economic headwinds, how does this impact your ability to cross sell interactive marketing services to your existing ecommerce customers? And secondly, one housekeeping item. Does your Q4 guidance include contribution from Innotrac?

Michael R. Conn

The fourth quarter guidance does not assume any contribution from Innotrac. We’ve put out there that we think it will close sometime in the first half of 2009. We’re hopeful first quarter but we obviously don’t know a specific date yet so it’s not yet included in our guidance.

Michael G. Rubin

From a cross selling of capabilities I don’t think we could be any more pleased than we are with the progress that we’ve made. I think you see that in two ways.

I think when partners are looking to extend, they’re often looking to add additional services into the relationship. A recent example would be Dick’s Sporting Goods who extended their relationship with both e-Dialog and GSI interactive with agency of record. Another example would be Aeropostale that moved their email business to GSI as part of the extension and also expanded their relationship with GSI interactive. World markets, there was an accretive customer that came through that position and then chose e-Dialog for their email services. Warnaco which owns certain of the Calvin Klein brands and Speedo also recently picked us for email and other marketing services.

So we’ve definitely been very pleased with our ability to upsell and cross sell, and also most important is the value that we deliver to our partners in helping them to do more business and ultimately not only make money by delivering the marketing services but by helping to drive more ecommerce transactions where we take a percentage of their sales.

Operator

Our next question comes from Christa Sober Quarles - Thomas Weisel Partners.

Christa Sober Quarles - Thomas Weisel Partners

I was wondering if you could give us some insights into traffic trends. I guess specifically what I’m trying to understand are consumers spending more time on the sites trying to price compare? Is there any correlation with in-store traffic as mall traffic sounds like it slowed down pretty precipitously at the back of September? Did you also see your own traffic die down? And is there any sort of diversion as it relates to certain categories in terms of how the traffic shifts occur? Obviously NFL, I can understand the seasonal stuff but I’m just trying to understand if there are any specific trends or data points around that that would be notable?

Michael R. Conn

Generally as we look at traffic trends, they’re fairly well correlated with sales trends. So if we see strength or weakness in a particular period, we would typically see traffic go along with that. What we’ve seen in our business really is a trend that’s been going for a while for us as traffic has been growing more quickly than transactions although I think that that’s less something that I would attribute to the current environment and more just a reflection of transactions that are being driven by online marketing have grown as a percentage of the total.

What we’ll typically see when that occurs is it drives a little bit of a different conversion but it’s not really attributable to site performance but more just as you bring in more traffic from external sites it converts at a little bit lower of a rate than direct traffic. I think a lot of that success that we’re seeing in growing that percentage of online marketing is that we’re really using that as a means to help our clients drive incremental transactions by online marketing. So I actually think it’s a good thing but it does mean the traffic grows a little bit faster than overall transactions.

Christa Sober Quarles - Thomas Weisel Partners

In the instances where you do have a marketing services relationship, is there any specific commentary that you can give as it relates to improved conversions or is that sort of a case-by-case?

Michael R. Conn

Typically when we look at marketing services engagements, we look at really: Is it driving incremental traffic? Is the ROI on the conversations that you get off that incremental traffic a good investment? We clearly are demonstrating that and we’re getting very good ROIs out of a lot of online market categories including display which has been growing nicely for us and I think that we’re actually taking advantage of the broader weakness in display to get some good results for our clients in that area.

We really look at it on an ROI versus a conversion basis because you will see as you dial up the spend in online marketing and you bring in more traffic from third party sites, it will cause a dip in conversions. But the ROI on the spend is very good and the transactions we’ve been able to demonstrate are incremental so it’s a good spend. It’s a good increase in business but it’s not necessarily measured by conversion rate.

Operator

Our next question comes from Nat Schindler - Merrill Lynch.

Nat Schindler - Merrill Lynch

G&A, the sequential decline, is there anything unusual in 2Q or anything unusual in 3Q that would cause that or was that just cost control and we should expect somewhere along these kind of lines in the future?

Michael R. Conn

One thing we noted last call that did stand out in 2Q that was more moderate and bouncing around from quarter to quarter is just legal expenses. So there were a couple items that hit us in 2Q where we had some heavier spending on that outside legal costs. That was certainly notable enough that we called it out in 2Q and that certainly helped us with sequential trends.

I think overall as we noted in the prepared remarks, we’re certainly paying close attention as we have been really all year to expenses and I think that we’re seeing some benefit from that as well.

Nat Schindler - Merrill Lynch

Non-one-time legal might bounce around with different events but true expenses for the business excluding what would be unnatural legal expenses, is this more the level at which they should be at and they will go from here or grow as the business grows or do you expect further declines?

Michael R. Conn

I think it’s reflective of a good run rate level and I think as the business grows you’ll certainly see growth over time. But I think it’s reflective of the current run rate. It’s not growing significantly at this point in time but certainly as we grow over time, it will grow.

Nat Schindler - Merrill Lynch

Are you sticking with your loose guidance of around 100 basis points of EBITDA margin improvement per year? Midpoint of guidance is about 130 basis points but you’ve been quite a bit ahead in the last two quarters, a lot because of really strong cost controls. Do you think that could continue?

Michael R. Conn

Yes. Certainly I think as we look at the business and the outlook for margins, we’re optimistic that we can maintain that rate. There are a couple things at play right now. Obviously one is focus on expenses. The strong performance that we’re seeing form marketing services is also clearly another factor.

The other things is that we’ve been through a period of pretty rapid expansion of facilities; we’re now growing into that capacity; and I think as we look in the future where we have additional clients where we need to add capacity, its impact on us will be much less than in this recent round just because of the base of the business being larger. So I think that also helps us as we look forward. We’re optimistic on the margin front. As I mentioned, we’re pushing and we’re finding that we’re just scratching the surface and that we have a lot of opportunities there. Certainly there’s a good outlook going forward on margins.

Nat Schindler - Merrill Lynch

With the World Series coming up with two relatively small market teams; not to belittle the Phillies, I’m sure you guys are excited about that; but is that going to hurt your Major League Baseball spend in the quarter which I believe is all product sales?

Michael R. Conn

Major League Baseball is actually a service fee client for us. I guess Major League Baseball and Major League Soccer are the two professional sports leagues that are service fees for us. It doesn’t impact the product sales line. We’ve really tried to have a planning discipline around the hot market events or the championships that is the plan for average teams and let it be upsided better, markets wins, so it’s not something that I would characterize as a big concern

We are insulted by your comment about the Phillies but other than that, it’s not an overall concern for us.

Operator

Our next question comes from Shyam Patil - Raymond James & Associates.

Shyam Patil - Raymond James & Associates

Could you just help me understand a little bit more how you exactly arrive at your comp store assumptions in the fourth quarter and specifically what gives you visibility into that? And my second question, with regard to the prospects in your pipeline for 4Q and for ’09, can you talk about how negotiations are progressing and how discussions are about around pricing as well?

Michael G. Rubin

I’ll hit the second question first. As it relates to overall negotiations from an adding new partners perspective, it’s always been a bumpy business since we founded the company in 1999. We continue to feel really good about where we are.

I think what has changed is that in this environment is companies only want to work with big and stable companies so our size and our market share and our scale is benefiting us more than it ever has. If you’re somebody thinking about moving your ecommerce business to another company for potentially outsourcing this business for the first time, you’re going to be more concerned than ever with making sure that you’ve got the right long-term very stable partner. So I think our financial strength and our size is definitely benefiting us and our leadership position is definitely benefiting us.

As I said a little bit earlier in the call, there’s no question that during this environment people are very sensitive about going out and making capital investments. So while we think our proposition’s been very strong and we’re having another great year from a sales perspective, I think the reality is the environment’s only going to further our lead just based on people wanting a predictable safe model with a big stable partner.

Michael R. Conn

On the comp store planning question, we utilize a bottoms up planning process that goes client-by-client. We base it off of run rate as well as what they’re planning for the fourth quarter, we look at how much inventory they’re bringing in, what their marketing spending plans are, how their offline business is trending; so a number of factors go into it. But it’s not a top down, here’s what we think comps will be. It’s really bottoms up partner-by-partner and how that unfolds into a comp assumption.

Operator

Our next question comes from Sameet Sinha - JMP Securities.

Sameet Sinha - JMP Securities

Incremental margins obviously are very good this quarter but you’ve been talking about cost controls in the beginning of the year. Did you increase the cost containment as you saw the quarter progress coming into August and September or this was all in the plan? Also, last earnings call you mentioned that you are really scrutinizing costs. Have you identified additional operational of capital areas where you could cut back costs?

Michael R. Conn

Certainly as we said earlier on in the year, we‘re mindful of the environment. It’s not a new phenomenon. It’s something that’s been around since about this time last year so we’ve been mindful of that and we’ve continued to really monitor things closely. Certainly as we got into the quarter and candidly just had concerns based on what we were seeing in the external environment, we continued to look for opportunities.

The good news for us is and one of the comments I made in the opening is we’ve been for close to 10 years now really in growth mode and we’ve grown very quickly. I think that when you do that and then you really start to look for cost opportunities, you can find a lot.

So we do continue to find opportunities. It’s not just in terms of staffing levels either although we’ve certainly been increasing our scrutiny on staffing levels but also on the purchasing side we’ve made a lot of success. Some little wins as well as some big wins but we’re going through all areas of spend as a company. We’re leveraging the scale that we’ve achieved, and we’re going back pushing hard on the vendors that we’re doing business with and having a lot of success and really have a lot of opportunities in front of us. It’s a continuing process. It’s not something that I think is near complete. It actually has us pretty fired up.

Sameet Sinha - JMP Securities

In terms of the cross sell and up sell, there are opportunities but we are here towards the end of October getting into the crucial holiday season. Do you think you can still win new business at this point or have plans already signed up and new store launches are imminent before the holiday season really begins?

Michael G. Rubin

I feel strongly that we will sign additional partners this year both in the core ecommerce services business and within both interactive marketing services businesses. We’re not planning for any of the ecommerce services agreements to get signed in 2008 to launch until 2009 so expectations should be sign additional deals in 2008, launch in 2009. The guidance that we provided today had us planning to sign partners, planning to work on some of those launches, but having the financial benefits start in 2009.

Sameet Sinha - JMP Securities

How much did you draw down on your line of credit? I could probably back into it but -

Michael R. Conn

We drew down $10 million so we finished the quarter at $40 million and late 3Q is really where we get into the peak of our cash needs. So our average on the line was less than that during the quarter and we’ve actually already brought it back down to around $30 million currently. But it ended the quarter at $40 million.

Operator

Our next question comes from Ross MacMillan - Jefferies & Company.

Ross MacMillan - Jefferies & Company

I just wanted to recap on something you said earlier. You said if we take the GAAP revenues, about 1/3 was organic and a 500 basis point impact from Linens. If I do the math, that suggests about 17% growth. Is that the right number?

Michael R. Conn

A little bit higher than that. It’s more than 500 basis points. Just under 20% would have been the organic if you back that out. Linens-N-Things and electronics.

Ross MacMillan - Jefferies & Company

On Dick’s transition, you didn’t mention that at all so I’m assuming that’s not any part of the fourth quarter change?

Michael G. Rubin

The transition’s set to take effect in February of next year and ultimately should provide a lot of acceleration to the business over time in that today Dick’s is not doing buy online, pickup in-store. They’re not doing in-store ordering for out-of-stock merchandise so when a consumer goes to the store and they don’t have the specific size or color, they’re not selling that merchandise to the consumer and then shipping it to their house. They haven’t yet aligned the assortment.

So I think we feel strongly and I think you’d hear Dick’s Sporting goods say the same thing that there’s tremendous upside in the business from where it is today over time based on getting them and the tools aligned, getting the pricing aligned and doing all the multichannel initiatives that are really going to drive the business. For many of our partners that do this well, people can do more than 50% of their revenue from some of the multichannel initiatives. But I imagine that Dick’s is not yet participating with.

Ross MacMillan - Jefferies & Company

I meant specifically from being an owned and [inaudible] service relationship and the implications that has for the GAAP revenues.

Michael R. Conn

That’s a 2009 event.

Ross MacMillan - Jefferies & Company

To recap again in terms of the cost structure, I think you said about 1/3 of the sales and marketing costs; these are rough numbers but about 1/3 of the sales and marketing costs are fixed so 2/3 variable. On a run rate basis, G&A and product development probably fixed, is that still ballpark the way we should think about it?

Michael R. Conn

It’s changed a bit just because we broke sales and marketing out into two separate lines. If you look at the two lines that we’re reporting now, the one that we refer to as marketing the biggest piece of that is the revenue share that we pay to owned inventory clients so the entirety of the marketing line is variable.

If you look at the line that’s called comp management and operations, it’s probably 60 variable, 40 fixed. The fixed expenses for operating facilities would be in there as an example of fixed expenses. Account management is an area that we would consider to be fixed expenses. It’s a little bit less variable than the net line but just because we’ve shifted out. So adding those two together, the relationship would be the same as what we previously said.

Ross MacMillan - Jefferies & Company

You are taking down Q4 by let’s say the midpoint it’s probably around just under $30 million but the impact to the adjusted EBITDA is obviously diminimus. It’s probably $2 million or $3 million. I was just trying to understand how I should think about that change on the revenue line versus the very small change on the adjusted EBITDA or non-GAAP operating income?

Michael R. Conn

There are a couple of factors there. The one that we’ve been talking about on the call is obviously expenses so I think that there’s some coverage for that revenue that we’ve taken down just with expenses.

It’s also really important to look at mix within that so I think the reason for the shortfall that we saw in the third quarter and that we noted was product sales. So when product sales are the source of a shortfall, the incremental margin on those product sales is a lot lower just because you’re recording those revenues gross. As a result the downdraft that creates on your EBITDA is a lot less than if it was service fee. So just based on where we’re seeing trends and how we’re looking at the mix play out.

I think that if we were to fall at the lower end of that guidance, we would attribute it more to product sales and a benefit that you would see that would just be less of an incremental margin as a result.

Operator

Our next question comes from Analyst for Jim Friedland - Cowen and Company.

Analyst for Jim Friedland - Cowen and Company

I just had a really quick question on marketing expense. It declined sequentially even as interactive marketing services revenues increased. Were there any key drivers in that or can you talk about that?

Michael R. Conn

Yes. That line item really ties to product sales as opposed to interactive marketing so it’s not the expenses of operating our marketing services division. It’s the out-of-pocket expenses that GSI incurs to drive its product sales business. That would include primarily royalty payments to owned inventory partners but it also includes subsidized free, our own online marketing expenses where we’re spending our own money to drive those sites. Most of that is just funded by an offset to royalty payments but it’s really GSI’s out-of-pocket and marketing expenses to drive product sales as opposed to the cost of the actual marketing services division.

Analyst for Jim Friedland - Cowen and Company

One other question on the segments. Q407 could you tell us what the EBITDA margin was ecommerce versus interactive marketing services?

Michael R. Conn

I’ll have to follow up with you. I just don’t have it sitting in front of me.

Operator

Our next question comes from Analyst for Brian J. Pitz - Bank of America Securities.

Analyst for Brian J. Pitz - Bank of America Securities

In terms of your use of capital, you’ve been talking about acquisitions, but I’m curious as to your thoughts about share repurchases given where your stock is trading?

Michael R. Conn

It’s something that we always evaluate over time. The bias of the company has been to continue to invest in growth. We still think that we have a tremendous runway in front of us. We’ve had what we believe is a lot of success with the acquisitions that we’ve made recently. We’re really pleased with them. We wouldn’t rule out share repurchases. We’ll continue to evaluate them as we always do. I would say that the likelihood is greater that you’ll see additional acquisitions from us but we don’t rule anything out.

Analyst for Brian J. Pitz - Bank of America Securities

I also know that you have some insight into the performance of the various online payment providers with all your partners. I was particularly interested in Bill Me Later if you’ve noticed any change in the consumer usage over the past month or so?

Michael R. Conn

I wouldn’t have that kind of real-time data on Bill Me Later. I can say it’s at a higher level. We’ve been a partner of theirs for many years. We’ve always pushed that on our clients and think it’s a good product. We have research that shows that it does drive an uplift of incremental transactions so we think it’s a good product. As far as if the current environment helped impact it in the last month, I couldn’t tell you off the top of my head.

Operator

Our next question comes from Herman Leung - Deutsche Bank Securities.

Herman Leung - Deutsche Bank Securities

Regarding the Innotrac acquisition you talked about potentially some cap ex savings given the amount of distribution centers that have already been built out and this acquisition has a bigger footprint. Can you better quantify the cap ex slowdown that is expected in 2009 with this acquisition?

Michael R. Conn

For us we’ve talked about cap ex, we’ve guided cap ex this year at $65 million and previously commented that we would expect it to be flat next year. That was in line with reiterating comfort level with consensus estimates for next year which I think are in the $100 million to $105 million range. We are very comfortable with that.

Innotrac should add a nice EBITDA on top of that if we had it closed on a pro forma basis at the beginning of the year, we’d expect to get another $8 million to $10 million of EBITDA out of it next year which would imply $65 million of cap ex and about $50 million of free cash excluding working capital. That’s an important objective to us. Some of it will depend upon the environment. I think that as long as we’re confident in the EBITDA side, we have opportunities; we certainly could spend up to $65 million in capital next year. At the same time it would be very easy for us to spend less.

Some of it’s just going to depend on the circumstances and how things play out. I think what is important to us is the drive toward that $50 million of free cash flow for next year which is a number that we believe is achievable under a number of different scenarios with EBITDA. But currently based on what we’re seeing, we’re comfortable with our ability to generate good EBITDA and as a result we might have to spend the capital.

Herman Leung - Deutsche Bank Securities

On Innotrac, one of their retail customers in Target, I guess you guys are doing some fulfillment there. Is there any opportunity for Target to potentially take up more services under you guys sometime in late 2009 or early 2010 especially as they want to migrate away from one of the larger providers out there?

Michael G. Rubin

Without commenting on Target specifically, what I would say is in any acquisition that we make that sells a subset of solutions that we provide, it’s certainly our goal to sell more services to all the partners wherever it fits.

One of the ways that we’ll measure the success of the Innotrac acquisition is to first and foremost look at the underlying EBITDA and cash flow and net income of the base business, and then what are the incremental services that we can sell to those partners. It’s certainly our objective when we make this acquisition to not only get a business that works financially for us and one that has good clients and one that helps us expand our capacity, but one that we can sell more services to.

Without getting into specifically any one customer, it’s definitely important to understand that it’s our expectation and goal to sell several incremental services on an as-needed basis to each and every of the partners.

Herman Leung - Deutsche Bank Securities

Given the economic uncertainty, how much are you guys baking in in the fourth quarter of a slowdown from Linens-N-Things or basically the general consumer slowdown? I was wondering if you can quantify if there’s more conservatism baked into the fourth quarter guidance numbers and if you can quantify what is the contribution from Linens versus just a general consumer slowdown or just partner slowdown?

Michael R. Conn

The best quantification would just be to look at the change in revenue guidance. Clearly that reflects an expectation that we’ll see a softer environment. Linens-N-Things is a part of that so I think that’s certainly reflected in there.

Beyond that I think it’s just an overall across the board conservatizing of what we rolled up just based on the fact that it seemed the prudent thing to do to be more cautious going into this quarter given the spending environment. Based on that relative to the trends that we’re seeing now I think we’re comfortable that we’ve taken the appropriate level of conservatism. We’ll obviously have to see how things play out as we get deeper into the quarter but we’re certainly comfortable with the haircut that we’ve taken.

Michael G. Rubin

It’s also worth mentioned. We have lots of our biggest partners that are doing great every single day. When we come in and we look at our comp reports on a daily basis of stores that have been with us for more than 12 months, we have some of our Top 5 and 10 partners every day that are +20, +30, +40. There’s always a mix of business but it’s definitely very important to understand that we have many partners, many of our biggest partners that are really doing very well. As Mike pointed out, there are others that are certainly experiencing some weakness but definitely some really good performance from some of our biggest partners.

Herman Leung - Deutsche Bank Securities

Are you factoring Linens-N-Things in 2009 if at all?

Michael R. Conn

We had assumed and really prior to finalizing ’09 plans had already assumed that they would be gone as a client. It was confirmation when that process finally unwound but it’s something that we had already planned for. I think it’s been a part of our planning process for a while now to plan contingencies into the business to have room for things like that to occur. So it’s a hit to us this year. It’ll be a hit to us next year but not something that we don’t’ think we can absorb and still meet what our goals are. I think people generally expected it.

Operator

Your next question comes from Colin Sebastian – Lazard Capital Markets.

Colin Sebastian – Lazard Capital Markets

First of all Michael just to clarify your last comments on the Q4 outlook, not to beat a dead horse here but are you characterizing the guidance as reflective of the present day environment or does the conservative view as you put it assume there’s further deterioration potential? Then my question is if it’s fair to characterize your business as moving to a more a la carte model, I wonder if you could give us some context on the pipeline in terms of splits between the business segments and within the ecommerce service segment where the pipeline stands?

Michael R. Conn

I think certainly there is a range to our revenue guidance and so I think as we look at that there’s certainly room within that overall range to see some softening and still be within that range. So I think that we’ve got some cushion, if we saw a severe erosion that would be another story but I think based on the trends that we’re seeing right now we certainly do have some cushion in there.

Michael G. Rubin

As it relates to your question to al la carte services versus end-to-end I think really what we’ve found is that based on having a limited profit base we’re only going after big enterprise customers in the ecommerce services business so call it maybe 1,000 prospects in the US. Selling them, which is what we did originally in the business the end-to-end model only is very limiting. So really, beginning in 2004 we evolved the business from not only offering end-to-end capabilities but also modular capabilities.

So someone can buy just fulfillment, or just technology or fulfillment and technology but not customer services, or certain marketing services. Today, it works best for us to really walk in to a customer and say, “Here are all the services that we have and we let you choose what you want to work with.” I think maybe half to two thirds of customers are buying us on an end-to-end basis and call it the other portion of the customers are buying us on a modular basis.

We think it’s really important to build relationships with a lot of modular arrangements because we’ve proven once you have a relationship with a partner you can do more with them over time. Once you’ve proven you’re a trusted partner you can add value to them, you can help them grow the business. So, we really believe start with a business partner with whatever services they want whether it’s end-to-end or modular and then do more things with them over time.

I think since we began selling modular services in 2004 it’s really been around the same ratios, half to two thirds doing end-to-end and the balance modular. I think our reputation is really of an end-to-end company but that’s really just something that we need to grow out of because it really is important to have all of the services both on an end-to-end and modular basis.

Colin Sebastian – Lazard Capital Markets

One last question, I apologize if you addressed this, I’ve bounced between a couple of calls. I think there was one prospect you had in the pipeline for Q4, to launch in Q4, any update there?

Michael G. Rubin

I think that was Big Lots is my belief and they launched yesterday. Big Lots was a great win for us, Big Lots it the largest closeout retailer in the US. I think it’s a $4 billion or $4.5 billion company. It actually launched with a pretty neat concept, a deal of the day concept where every day they have a new deal. That launched yesterday, I think over time they can have a very successful ecommerce business. Again, that was an end-to-end partner, fulfillment, customer service and technology.

Colin Sebastian – Lazard Capital Markets

So nothing else launched in this quarter?

Michael R. Conn

Calvin Klein launched in the quarter, I think Kenneth Cole actually launched at the beginning of the quarter, so there were some additional launches that took place in the quarter.

Michael G. Rubin

I think we’ve finished all the launches that we have coming. We’ve launched all the sites so far that are going to launch this year. We believe we’ll assign additional partners in 2008 that will launch in 2009 but we’re not planning for any additional launches in 2008.

Operator

Your final question comes from Atul Bagga – Thinkpanmure, LLC.

Atul Bagga – Thinkpanmure, LLC

A couple of question for you guys, you talked about the value proposition for outsourced ecommerce is better in this market. I was wondering if you can share any evidence either on lead generation or around comp data win rates or even in terms of how it is helping you in the current sales cycle? The second question is about the cross selling, up selling opportunity, can you share some thoughts on how many of your [inaudible] marketing customers are already ecommerce customers and vice versa?

Michael G. Rubin

As it relates to just some kind of anecdotal evidence as it relates to the value proposition, first and foremost our value proposition we believe has always been very strong. We’ve been a real leader within the ecommerce services businesses. With that said, I think what I’m seeing are different types of questions today which are leading us to believe that the value proposition is even stronger during these times.

One is questions around size and stability and when people are asking about our size and stability and we’re really I think the most successful company in this business, ecommerce services for physical goods, there’s no question that I think it’s going to be difficult for smaller companies to be successful so that’s the first sign. I think the second thing is there was a point of time when certain companies were looking to not only pay variable fees but also spent certain capital in to the deal and what we’ve seen recently is companies really want complete [rev sure] basis, very predictable, no risk, no capital.

So I think there’s definitely a tightening from a capital spending perspective which again plays really well to our overall model. As it relates to cross selling and up selling a little bit earlier in the call I mentioned a bunch of examples of customers that came in through one business and have bought multiple services. I’ll say it again, we could not be happier with the progress that we’ve made in selling GSI Interactive and e-Dialog services to many or our ecommerce platform services clients and vice a versa.

I think we’re definitely making tremendous progress there. I think it’s one of the things we’re using to evaluate acquisitions we make. It’s not only kind of what’s the base business that we bought but how much up selling and cross selling can we do within the GSI family of clients.

Atul Bagga – Thinkpanmure, LLC

If I may can I ask a follow up on this? Can you somehow quantify what could the opportunity for cross selling and up selling within your install base?

Michael G. Rubin

Let me give you an example with e-Dialog, I think that might be an easy way to think about it. If you think about e-Dialog’s business we’ve always had call it a $50 million plus business in 2008. Before we acquired the company maybe 10% of the business came from GSI clients and that was coincidence. They had worked with several GSI clients before we bought the business, companies like American Eagle, the NFL, NHL, HP so they worked with several of our clients.

With acquisitions we look where does this go long term. I could certainly see GSI commerce platform clients being 25%, 30%, 35% of e-Dialogs business and that’s at the same time with the existing install base growing very quickly and their also adding several new partners every single year. So, I think that’s a great example and a significant business to us of how many meaningful the cross selling opportunities can be.

Operator

There are no more questions at this time.

Michael R. Conn

Thanks everybody for joining us tonight. We look forward to talking to you after our fourth quarter.

Operator

Thank you for your participation in today’s conference. This concludes the presentation. You may now disconnect. Have a great day.

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