GSI Commerce: An Underestimated eCommerce Pure Play (GSIC)

Following a meeting with GSI Commerce (GSIC) management last week, Stifel Nicolaus analyst Scott Devitt is convinced that his recent upgrade of the stock was the right move. Here are his takeaways:

We believe the market underestimates the long-term margin potential of the business as the company continues to invest in its platform. We have always been enamored by GSI's strategic position but were never able to gain comfort with the company's inability to transfer revenue growth to EBITDA to cash earnings. We believe the Toys R Us deal is very significant to the company gaining the scale necessary to transfer revenue growth to profit growth. We estimate that Toys will account for as much as 25% of 2007 net merchandise sales and 7% of revenue. We think the EBITDA from Toys will amount to as much as 18% of the $55 million in EBITDA we expect the company to generate in 2007. We also believe Toys gives GSI the flexibility to invest in worthwhile projects that it otherwise may have deferred. We would not be surprised if the company invested in its sales division in 2007 to drive its partner addition number above the high-end of the historical range of five-to-ten new partners per year.

We believe the environment for pure-play ecommerce companies has changed materially in the past eighteen months and we find GSI to be a distinct beneficiary. In 2005, fourteen GSI clients generated more than $20 million in annual revenue compared to nine in 2004.

Two landscape changing events have occurred – (1) the costs of driving traffic to ecommerce sites has increased at a 25+% rate over the past two years, and (2) traditional retailers have become more aggressive with investments in multi-channel retailing,

We have often referred to online retail as a "bring your own traffic" business. Pure-play online retailers do not have a traditional storefront, lack foot traffic, and have no immediate brand recognition. In traditional retail, the store owners have the capacity to leverage the capital deployed by real estate developers building store fronts in heavily trafficked areas. In the traditional world, there is a business in building shopping centers and creating an environment for consumers to shop. To the retailer, the cost is known as rent. On the internet the equivalent of the shopping center developers include Google, Yahoo, shopping comparison sites, etc., and to the pure-play retailers rent is high. We estimate 25+% annual increases in online advertising costs in the general commerce category over the past two years and we believe traditional retailers will continue to drive costs higher over time. Another constraint for pure-play commerce companies is the cost of one-at-a-time shipments versus the bulk shipments to storefronts which occur in traditional retail. As Amazon has proven, the returns on capital can be very high as an online retailer but only with a sufficient amount of funding to allow the business to reach scale. Today, Amazon is the only pure-play general merchandise Internet retailer to have reached sustained profitability in the world.

Traditional retailers are using an internet presence to drive traffic to stores and utilizing brand advertising on the Internet as an alternative to print, radio, TV, and other traditional media outlets. We believe retailers should view their online operations as more than "just another store." According to surveys on GSI partner sites more than 20% of customers have visited the Website within the past thirty days to research product before purchasing product at a physical store. Another study cited by GSI found that more than 90% of people ages 18 to 54 use the Web to research product online. Importantly in this environment, GSI must manage its business to the level of satisfaction expected from the retailers that it partners with and, along these lines, GSI has only lost one partner of size (Kmart) that we are aware of over time, indicating that GSI provides excellent service both to its partners and to its partner's customers. In the end, it is the partners brand on the line.

According to the recently released Internet Retailer 500, GSI now has fourteen partners generating more than $20 million in annual revenue based on 2005 numbers. Toys 'R US $429 million, Palm $118 million, Polo $85 million, Radio Shack $79 million, Linens 'n Things $70 million, NASCAR $70 million, MLB (shopping only) $58 million, NFL $58 million, The Sports Authority $55 million, Dick's $54 million, Gloss $32 million, Zales $25 million, Tweeter $25 million, and Liz Clairborne $23 million.

GSI, in our view, is fully levered in a positive manner to the increasing costs of advertising on the Internet and the focus of traditional retail to utilize the internet as not only a commerce engine but an acquisition tool for its physical stores.

The changed landscape has driven GSI to invest in its business to meet the increased demand for both its core retailing platform and its newly-created marketing services platform.

GSI expects to increase fixed overhead costs structure by $20 million in 2006 to enhance its platform with investments being made in all key areas of the business, including technology, logistics, customer care and marketing services capabilities. One-third to one-half of the incremental spend is in marketing services. Interestingly, two-thirds of customers are now using GSI to place their online advertisements.

The technology component of GSI's offering includes Web site administration, Web infrastructure and hosting, business intelligence, ecommerce engine, and order management. The logistics and customer care component of GSI's offering includes fulfillment, drop shipping, customer care, and buying. The marketing services component of GSI offering includes creative design, interactive media buying, customer insight and communication, imaging, and partnerships/alliances.

In our view, a more diversified product offering by GSI has significant long-term benefits to its franchise. For GSI to be successful, its partners need to be able to grow their multichannel business faster and more profitably than they could on their own. This has led to GSI's investment in its marketing services division. Currently about 9% of GSI's total workforce resides in its marketing services division and approximately 18% of those at the company's headquarters. At a product offering level, marketing services include strategic online marketing, planning and consulting, ROI modeling, forecasting, competitive analysis, search and affiliate marketing programs, online advertising, comparision shopping engine marketing, short message servicing, SMS marketing, and marketing through emerging platforms such as I-TV and wireless.

We expect GSI to add PayPal as a payment option in 2006. PayPal studies have found its implementation to be additive to sales of partners sites by as much as 14%.

GSI already offers Bill Me Later as a payment alternative option to its partners. We expect a similar PayPal implementation in 2006. PayPal generated $27.5 billion in payment volume in 2005. PayPal offers industry-leading fraud management and an alternative payment platform that can cause a double-digit lift to partner sales according to PayPal studies. We expect that as much as $100 million of $1.6 billion in GSI net merchandise sales could be paid with PayPal in 2007, not a material number to PayPal but, if PayPal is truly incremental to business this integration could provide a modest lift to GSI's published estimates.

We believe the company is at the beginning of a several year trend of improving margins and profit flow through. We find it to be true that many times it is the businesses that take the most to build that have the most sustainable and lasting economic value.

We believe if GSI stopped adding new partners and new offerings to its platform following the integration of Toys 'R US that the company could generate more than $70 million in EBITDA in 2007 and as much as $0.75 in cash earnings. The company would be growing at the rate of ecommerce (20%) and trading for less than 9x EBITDA and 22x cash earnings. We display this scenario because we believe it shows what GSI could be doing currently if it chose to maximize earnings at the expense of the long-term value of the business. Instead we expect the business (net merchandise sales) to grow above 35% and generate $55 million in EBITDA and $0.51 in cash earnings. The investment in new partners and in infrastructure makes the business seem more expensive but, in our view, is the right move by management. We expect management to be disciplined with shareholders' capital as it grows the business and we believe the company is at the very beginning of experiencing the benefits of its investments. We have found that companies in this sector approaching operating leverage tend to outperform. For GSI, we expect 2007 EBITDA growth of 53% and 2007 cash earnings growth of close to 200%. We believe that operating leverage will continue in 2008 and 2009.