GSI Commerce: Outsourced E-Commerce Provider of Choice (AMZN, GSIC)

From Stifel Nicolaus analyst Scott Devitt's note to clients outlining his rationale for upgrading GSI Commerce Inc (GSIC):

* We are upgrading shares of GSI Commerce to Buy from Hold and initiating a $20 12-month target price. Our target valuation, amounts to 39x 2007 cash earnings and 14x EBITDA. We believe the business is approaching a leverage point in terms of converting EBITDA to cash earnings, which will become increasingly visible in 2007 and 2008. In 2007, we expect EBITDA growth of 49% and cash earnings growth of 183%.

* Yesterday, GSI Commerce announced that it signed a long-term agreement to provide Toys "R" Us with an ecommerce solution for all of its branded stores, including toysrus.com and babiesrus.com. GSI Commerce will provide technology, customer service and support, and Exel (a unit of Deutsche Post World Net) will provide fulfillment services. The transition to the new platform is expected to occur on July 1, 2006.

* We are increasing 2006 estimates as follows – net merchandise sales to $1.2 billion from $955 million, revenue to $600 million from $571 million, EBITDA to $36 million from $35 million, cash EPS to $0.17 from $0.16. For 2007, we go to – net merchandise sales of $1.62 billion from $1.17 billion, revenue of $742 million from $684 million, EBITDA of $55 million from $47 million, cash EPS of $0.51 from $0.36.

* In 2005, the internet operations of Toys "R" Us generated $429 million in revenue, up by 17% from the prior year. We expect Toys to generate approximately $450 million in 2006 and we estimate that GSI's deal is based on 12% economics under a service fee agreement. We expect Toys to be $57 million additive to GSI on an annualized basis with 22% EBITDA margins or $12 million of EBITDA. We believe that GSI Commerce will incur upfront costs in 2006 that remove EBITDA upside and that the company will invest as much as half of the benefit of the deal in 2007 back in the business.

* In early March, Toys "R" Us announced that it had prevailed in its litigation with Amazon.com (AMZN) in a suit filed in May 2004, related to Amazon's breach of contract. Amazon appealed the decision and requested that the judge offer a stay; the stay was denied. Then, Amazon submitted a request to stay with the appellate court; the request to stay at the appellate level and the appeal remain outstanding. The appellate court did deny a request by Amazon to accelerate the stay review, we have been told. We believe that Amazon's intent with the appeal is more likely monetary in nature than it is an attempt to maintain the operating relationship. Given this belief, we find the likelihood of anything other than Toys paying Amazon a dollar amount to exit the agreement to be unlikely. We would also note that GSI would be compensated by Toys "R" Us should the litigation force Toys to remain with Amazon.

* We believe GSI Commerce has carved out a niche as the outsourced ecommerce provider of choice and find the growth of Google (and Google Base) to be net positives to GSI's business over time versus competition in the third-party retail category (Amazon). Historically, retailers chose Amazon over GSI due to scale and distribution; now, we believe GSI is big enough to handle most any deal and that search engines provide replacement distribution when compared to the retail aggregation points such as Amazon. We should note that we continue to find Amazon's differentiation based on convenience, selection, and price, to create a loyal customer base, to be a compelling value proposition; in that regard, there is no change to our view.

* Another legacy challenge that GSI has faced is the amount of scale required to make its business consistently profitable. While we have always been enamored by the competitive position, we have been reluctant to recommend the shares given the lack of historical transfer from revenue growth to EBITDA growth to cash earnings growth. With this in mind, we believe Toys to be relevant as GSI now provides services for more than 50 partners and the Toys deal will propel NMS to above $1.5 billion in 2007. At $1.5 billion in NMS and $55 million in EBITDA, GSI will be able to generate $0.51 in cash earnings a 143% increase over 2007. We believe the leverage continues in 2008 and beyond, providing much more palatable valuation metrics over time.

* Finally, in 1Q06 GSI executed well against our metrics for the business including 40% sporting goods revenue growth, 54% service fee revenue growth, and a 41.3% gross profit margin (up 440 bps YOY). Net merchandise sales [NMS] from sporting goods and other product revenues (Palm) declined to 54% of total NMS from 62% last year, a metric we pay close attention to and one that is a significant positive trend in our view. Also, inventory turns improved to 6.6x from 5.4x last year. Also, sales and marketing spending as a percentage of NMS was 15.4% consistent with 1Q05 levels despite increasing online advertising rates.