Seeking Alpha
We cover over 5K calls/quarter
Profile| Send Message| ()  

GSI Commerce, Inc..(GSIC)

Q2 2006 Earnings Conference Call

July 26 2006, 4:45 p.m. EST

Executives

Michael Conn - Chief Financial Officer

Michael Rubin - Chairman, Chief Executive Officer

Analysts

Shawn Milne - Friedman, Billings, Ramsey & Co.

Anthony Noto - Goldman Sachs

Paul.J.Bieber - Piper Jaffray & Co.

Colin Sebastian--Lazard Capital Markets

Scott Devitt - Stifel Nicolaus & Company, Inc..

Mark May - Needham & Company

Chad Bartley - Pacific Crest Securities

Robert Peck - Bear Stearns

Jim Friedland - SG Cowen & Co.

Paul Keung - CIBC World Market

Presentation

Operator

Good day ladies and gentlemen, and welcome to the Fiscal 2006 Second Quarter Operating Results of GSI Commerce. My name is Michelle and I’ll be your coordinator for today. [Operator Instructions]. As a reminder, this conference is being recorded for replay purposes.

I'd now like to turn the presentation over to your host for today’s call, Mr. Michael Conn, GSI Commerce' Chief Financial Officer. Please proceed.

Michel Conn - Chief Financial Officer

Thanks Michelle, and good afternoon everyone. Welcome to GSI Commerce Conference Call for the Second Fiscal Quarter ended July 1st, 2006. This is Michael Conn, GSI's Chief Financial Officer, and I'm here with Michael Rubin, our CEO.

I'd like to comment on 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”, 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 will also present certain non-GAAP financial measures, adjusted EBITDA and merchandise sales and certain ratios that use these measures. In our Form 8-K, which is located on our website at www.gsicommerce.com in the pressroom section, you’ll find our definitions 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.

We had an excellent second quarter with both revenue and profitability ahead of our expectations. Net revenue on a GAAP basis for the quarter was up 30% versus last year and was our strongest quarter over quarter increase in net revenue from the previous four quarters. Non-GAAP merchandise sales or total transaction volumes through our platform increased 52% versus last year. This is on top of merchandise sales growth of 53% and 63% in the second quarters of fiscal 2005 and fiscal 2004 respectively. Merchandise sales were strong throughout the quarter with normal drivers including Mother’s Day and Fathers’ Day gift giving, new product introductions in electronics, June clearance activity, and the NHL Stanley Cup Playoffs. Merchandise sales transfer boosted on a sequential basis by the launch of the NFL in our platform, which actually occurred in the last date of first quarter and Doctors, which occurred in June. Toys “R” Us and Babies “R” Us launched in the last day of the second quarter, and did not have an impact on the quarter’s revenue.

Overall, our merchandise sales growth again reflected strong comp. store trends and solid contribution from new stores that were not in our platform for the entirety of Q2 fiscal 2005.

From a category standpoint, our three largest merchandise sales categories for the quarter were sporting goods, electronics and apparels, and our three fastest growing merchandise sales categories were health and beauty, home and electronics. Sporting goods represented 34% of merchandise sales in the quarter compared to 37% last year and despite declining as a percentage of total merchandise sales, sporting goods did experience 36% growth for the quarter. No category other than sporting goods represented more than 20% of merchandise sales for the quarter. We continued to see favorable trends in terms of partner concentration. As our top five partners represented 48% of merchandise sales in Q2 of ‘06 compared to 60% in Q2 of last year.

Our largest partner accounted for 14% of Q2 merchandise sales this year compared to our largest partner representing 21% of Q2 merchandise sales last year. Our partner concentration may shift negatively over the next few quarters until we anniversary the edition of Toys “R” Us. Product sales represented 46% of merchandise sales in Q2 of this year compared to 55% in Q2 last year. We expect the product sales as a percentage of total merchandise sales should continue to decline as our non-owned inventory partners continued to increase in their contribution to total merchandise sales. On a trailing 12-month basis, sporting goods merchandise sales surpassed $300 million. Non-sporting goods merchandise sales surpassed $500 million. Total merchandise sales surpassed $800 million and service fee revenues surpassed $100 million, all milestones for GSI.

Our gross margins in the quarter improved 140 basis points from last year. With strong growth and service fees more than offsetting a decline in product margins. The decline of product margins resulted primarily from a mix shift between sporting goods and electronics, and lower realized gross margins in electronics. The lower gross margin rate in electronics is offset by a corresponding reduction in sales and marketing expense. Sporting goods margins for the quarter did increase on a year over year basis. Service fee growth, which was above 50% for the second consecutive quarter was driven by comp and non-comp transaction fees and continued strong performance for marketing services.

In addition to higher sales volumes, lower sales and marketing expenses relative to our plan for the quarter were source of upsides for us and were driven by variable operating efficiencies and our fulfillment and customer service operations. Product development expenses were up significantly on a year over year basis and up slightly sequentially as we continued to invest to enhance our technology platform. We expect further sequential increases in product development expenses in the back half of fiscal 2006, as we continue this investment in the technology platform. The year over year growth in G&A expense was consistent with the overall growth of our business.

As part of our quarterly results, we again recorded a charge related to our investment in Odimo Inc.., this time for approximately $400,000. Odimo is a public company that operates in the e-commerce jewelry sector. We received the shares in 2002 when we sold certain assets of Ashford.com to Odimo. The impairment is non-cash, and is not something that we view as reflective of our operating charge. Prior to the charge, the carrying value of the investment $1.3 million and the charge takes it down to $900,000 which was the market value at the end of the quarter. Overall, adjusted EBITDA, which excludes the impairment charges I just discussed, grew 19% for the quarter to $2.8 million from $2.3 million last year. Net loss for the quarter, which includes the $400,000 Odimo impairment charge, was $3.6 million versus a net loss last year of $2.9 million.

Looking at our balance sheet on a year-over-year basis, cash and marketable securities increased $11 million from $118 million to $129 million. Inventory was essentially flat over the last year although we do expect inventory to increase in Q3 as we built for the holiday season. The increase in both other current assets and deferred revenue reflects expenses and revenue the project and implementation work related to activities during the second quarter that will be completed in later periods. These revenues and expenses will be recognized upon completion of projects. This is a combination of some launch related work where we received implementation fees, some larger marketing services projects, and some incremental technology work.

Turning to our guidance, let me start with Q3. We are looking for a sequentially increase in merchandise sales and an acceleration in year-over-year merchandise sales growth, largely driven by the addition of Toys “R” Us. Net revenue is expected to decline sequentially and grow year-over-year at similar to slightly lower levels in Q2, at an increased rate of service fee growth is expected to be offset by a lower rate of product sales growth. The lower product sales growth is primarily a non-sporting goods owned inventory businesses. Gross margins are expected to increase sequentially and year-over-year driven by strong service fee growth. Offsetting the expected increase in gross profit will be higher operating expenses particularly in product development reflecting investments in technology and in sales and marketing reflecting over a million dollars in catalog cost for our NFL business, that were incurred in Q3 but they primarily benefit revenue and gross profit in Q4.

The high end of our adjusted EBITDA range is relatively flat with last year’s results, for the year we’ve raised both our merchandise sales and net revenue growth expectations, higher merchandise sales expectations reflect the upside in Q2 as well as the additional of Toys “R” Us and solid business momentum. Our increase in net revenue guidance reflects the upside in Q2, higher service fee expectations and slightly lower product sales expectations. This is in line with the normal ups and downs we typically seem in a partner-by-partner basis, and is primarily the result of lower expected products sales for the non-sports owned inventory businesses.

We are raising the low end of our adjusted EBITDA range for the year to $33 million, for a new range of $33 to $35 million compared to pervious guidance of $32 to $35 million and our guidance at the beginning of the year of $30 to $35 million. This reflects the upside in Q2 and relatively consistent expectations for the balance of the year with higher merchandize sales offset by more investment spending. The high end of our income guidance is down by a million dollars to $6.5 million from $7.5 million, 400,000 of which relates to the Odimo impairment and the balances due to higher depreciation related to increased capital spending levels On our last call, I mentioned our plans to open a new call center facility this year and we are pleased that we are making good progress towards securing a location. Based on the quality of the properties that we are looking at, and our expectations to utilizing the new facility is a core part of our long-term infrastructure, we decided to purchase rather than lease the facility pending finalizing the deal. If completed, this will represent the fourth owned facility including our two headquarters facilities in (inaudible) and one of our two fulfillment centers in Kentucky.

In addition to the purchase of the call center, the citing of the Toys “R” Us deal has led us to accelerate several technology related capacity investment to prepare us for a more significant fourth quarter peak that previously planned. While we are making these capacity investments earlier than planned, we believe the incremental capacity would have been needed by next year and by doing it all at this time, we can obtain better pricing. Primarily the result of this decision to purchase a call center and the additional technology capacity spending, we now expect capital expenditures for the year of approximately $40 million to $45 million versus previous expectations of $30 million. While we recognize this as a big increase we are excited about the projects and we believe the increased investment will be beneficial for the company. We would also like to note in the cash flow statement that was included in our press release, did note that it was for the three months ended July 1st 2006 and that should have actually read for the six months ended July 1st, 2006 we note that as a correction.

And finally, before I turn the call over to Michael Rubin, I want to address questions we have received from investors regarding the issue of stock options accounting specifically with media attention the subject has been getting, we’ve been asked whether or not we believe we have any issues. Let me say we have looked internally at the matter and we are satisfied that our investors can continue to rely on our financial statements. And with that let me turn it over to our Chairman and CEO, Michael Rubin.

Michael Rubin – Chairman, Chief Executive Officer

Thank you, Mike. I'm very happy with the results of our Q2. Our performance exceeded the high-end of our guidance for net revenue, merchandise sales adjusted EBITDA and net loss. The growth in our net revenues and merchandise sales continues to be an indicator of growth of our partners’ e-commerce businesses as well as the continued help of the e-commerce industry. We topped the high end of our adjusted EBITDA guidance by $800,000 and our net loss guidance by $1.1 million even as we continued to invest in our platform during the quarter.

The Q2 results have provided us a strong momentum as we enter the second half of the year. We are $200 million in merchandise sales for the quarter, a 52% increase over the last year’s Q2 and it didn’t include any contribution from Toys “R” Us. It is the type of growth together with a continuing strong pipeline of prospective partners, which makes us very optimistic about the rest of the year and beyond. The most notable accomplishment for the quarter of course, was the signing and subsequent launch of Toys “R” Us and Babies “R" Us. In terms of merchandise sales we expect Toys “R” Us to be our largest partner agreement the company has signed. While I won’t comment on the specifics, I can’t say that we believe the Toys “R” Us is a good financial deal for the company. We are pleased with the performance of the side this far and we were now busy preparing additional enhancements, which would be implemented during the second half of the year and in fiscal 2007.

I’m also happy to report that our marketing services group was selected by Toys “R” Us to provide online media buying, e-mail creation and delivery, website design, digital photography services to Toys “R” Us. This was separate from our core e-commerce deal and it is indicative of the strong value preposition we are building with our marketing services efforts. It is also worth noting that while the signing and launch of Toys “R” Us during Q2 was a notable accomplishment, I’m equally excited about the fact that we achieved this in a short timeframe and without any disruption to our core business.

During the quarter, the company also launched Dockers Online Store. This is the second Levi’s and Strauss site to go live on the GSI Commerce platform. Yesterday, we announced that we signed that we signed a multiyear agreement to provide a full service e-commerce solution to the global fashion company, BCBG Max Azria Group for its BCBG Max Azria and BCBG Girls brands. With an expected launch in Q1 of 2007, we are providing their web stores with online technology, fulfillment and customer care operations. Revenues from the partner will be recorded as service fees. And today I would like to announce the company assigned a multiyear agreement with a new unnamed health and beauty partner. The partners expected to launch their e-commerce operations in Q4 of this year. Revenues from the partner will recorded as service fees. The agreement includes technology fulfillment and customer care.

Additionally, I would like to announce that Iomega International went live in July and is now operating on our international technology platform and servicing online shoppers in 47 European countries. To date, the company signed seven new partners for fiscal year 2006, six domestic and one international. Of these seven, four are launched including Toys “R” Us, NFL, Dockers, and Iomega International. Again, our pipeline is very solid and I expect that we will sign additional agreements in the coming months. I continue to believe we have reached the high end of our annual goal of signing 5 to 10 new partners.

We continued to be excited by the growth of our marketing services efforts. We are building what we believe is a world’s first full service interactive agency with expertise in website design, online media buying strategy, e-mail marketing, and digital content services. Our focus on multi-channel e-commerce and our expertise to ride from the operation of our core e-commerce platform are clear differentiations for our agency. As Mike mentioned, we are excited to be close to completing the purchase of a second call center. Not only will this provide us with the needed additional capacity, but the added redundancy will also enhance our value proposition to partners. We also plan to invest in the state-of-the-art switching capabilities in order to leverage the work forces of the two call centers together as if they were of single virtual call center which we expect to yield additional efficiencies with GSI.

We continue to invest in our technology platform to enhance the features and functions of the consumer shopping experience and to provide easier site management capabilities and enhance business intelligence to our partners. We have recently announced the release of two new exciting features, Express Shop and Mini Card, which we launched for air pistol during Q2 and that we expect to roll out to many additional partners. These exciting new web 2.0 features are built with HX technology and allow online consumers to view additional product detail, purchase multiple quantities and colors of a product and view and add products to the shopping cart dynamically always out-leaving the web page on which they’re shopping.

Some of the other more noteworthy we anticipate make into our platform this year, including enhancing and upgrading our navigation and parametric search capabilities, enhancing our order management capabilities and upgrading and streamlining the consumer product return process. Before I conclude, I want to address a few questions we have been asked since we signed the Toys “R” Us agreement. People were asking us why we are not making more money in the near term. They were asking us if the Toys “R” Us agreement is financially sound for GSI and they were asking us about investors with (inaudible). Let me stop by reiterating that we are very exited about the Toys “R” Us deal and we believe that is a good financial deal for the company. In general we have done what we believe a good win-win deals with our partners and believe that we have a sound price and discipline in place, enables us to know what makes a good deal.

The reality is that we really do believe that we could be making a lot more money in the near term if we are not taking a longer-term view of the business. Perspective is important considering that we have only been around for seven years, we were operating in a very high growth industry and we continue to see a much greater opportunity in front of us. We will never realize our full potential if we do not invest to grow the business. We are not investing against a backdrop of a business that is not working, but much to the contrary, we are seeing excellent demand from consumer shopping online and major enterprise that see the value that a platform can add to their businesses.

We are also seeing real evidence of the benefits of scale as we get larger. Let me provide some color on the areas in which we were investing or expect to invest going forward. First, marketing services. As I mentioned earlier, our efforts to build a full service interactive agency gaining traction and we are focused on positioning ourselves to take advantage of what we expect to be a substantial growth trend of companies investing more in the website and more in online marketing.

Our partner bases have very large active offline marketing spend and we continue to expect a meaningful amount of this spend in shift online over time. The next is international. The international e-commerce market is growing faster than the US market and is expected to be a larger market, yet it represents less than 5% of GSI’s business today. We’ve started to lay the groundwork to drive international expansion but there is clearly some upfront investment required to get this going. Third, sales, we have held our investment and our sales figures are roughly flat to the last three years, we have consistently generated the five to ten deals per year that has been our target. We believe that with the increase in infrastructure it could be possible to accelerate the pace of new deals in future years when we will first need to invest to increase the size of our cells organization.

I would also note that the addition of income on sales resources could enable us to target additional categories as well. Our great technology invested into three core areas. First is capacity, which is driving a chunk of our increased capital spending claims for this year. We offer premium solution with a high degree of work redundancy, security and high quality of hardware and software components. Any capacity could be expensive but it is a core part of our value proposition and we certainly benefit from buying efficiencies, as we get larger. Second is our underlying architecture. We have been undergoing and will continue to undergo a series of key projects aimed at approving the agility of our development capabilities and the stability and reliability of our platform, while reducing every time our underlying cost structure, and third, we have invested in what we refer to our product roadmap. These are features and functions such as Expression shop and mini cards that I discussed earlier as well as hectic management tools used by our partners, business intelligent capabilities and adding new multi-channel options.

The realty here is that we have the ability to move the capabilities of our site’s board at a far greater rate than our partners can do own their own and this is a key piece of our value proposition. Overall, between operating expenses and capital expenditures, we expect to invest approximately $60 million in our technology platform this year. Five, next we have invested in our operations infrastructure notably the addition of a second call center and a third fulfillment center in 2007. Obviously, there’s historic cost associated with these investment, but we are confident of the return on investments makes this investment very good thing for our company to do. We believe that in addition to the second call center and third fulfillment centers should provide the capacity to exceed $2 billion in annual merchandise sales.

Lastly, with all this growth and investment and cooperation for the company, we continue to be mindful of the need to invest in G&A, support including human resources, legal, finance to ensure that we have the appropriate corporate infrastructure in place to manage larger business that would be coming. This is not an all-inclusive list but it does cover a great deal of what we are focused on at the moment. We certainly understand the desire from investors to see more of near term profits, I think it’s important to consider how fast we are growing, how much opportunity we have in front of us and how much overall value we create longer term by continuing to ensure that we make the right investments in the business today.

We now expect to generate more than 1.1 billion in merchandise sales this year, which would be an increase of more than $400 million in one year off the base of $682 million last year. While we are growing at a tremendous rate, we continue to expect meaningful increases in adjusted EBITDA and net income this year, while cash levels are remaining relatively unchanged demonstrating that while we are investing aggressively, we are doing so with a strong underlying discipline. Overall, I would summarize by saying that we feel great about our current results and our prospects. We have taken a long-term view of the business, but believe that the near-term results we are delivering and project and demonstrate the progress of the business is making to the stronger, profitability profile in the future.

And with that, I would like to turn the call over for your questions.

Question-and-Answer Session

Operator

Thank you, sir. [Operator Instructions]. And our first question comes from the line of Shawn Milne, please proceed.

Shawn Milne - Friedman, Billings, Ramsey & Co.

Thanks, and good afternoon. Good quarter, guys. A couple of questions, first on the ‘06 guidance and then the follow up just on longer-term expectations. If I look at what you have raised in net merchandise sales for the year, the change if I count in the upside in the quarter, it looks like you’ve raise NMS by about $150-$175 million it looks like that would be obviously the change with Toys “R” Us, is that a conservative expectation for Toys “R” Us, can you walk us through that? And then I a follow up you know, you’re talking a lot about investment and capacity down the road, Michael Conn, if you could tell us, out of the $40 million, how much is associated with the decision to purchase the call center versus lease and would you expect CapEx to be at that same kind of level on those seven or can it decline a little bit against expectations of $50 million plus in EBITDA, thanks.

Michael Rubin

Sure Shawn, I’ll take the first part of the question regarding the guidance. I think your math is right that the incremental guidance in our numbers is here somewhere $175 million, and if you took Toys “R” Us out of our guidance we would be up a little bit against the previous guides that we gave at the end of Q1. So I think our approach is certainly everyone saw that the published numbers of Toys “R” Us that it was a much bigger number than that, last year, but we want to get some history under our belt. This is a big business it’s our –- going to be our first how this is in running the business, so certainly I think our expectations are very bullish for the business, but we think what we are going to do is take a conservative approach toward estimating the business and that is the way that we thought about it and the way that we guide it towards the business.

Michel Conn

On the CapEx question, Shawn I guess I would say about half the increase in our CapEx guidance has been driven by the call center. Most of that is related to the purchase. There is a little of spending beyond that, but the lion’s share of that -- of the increase is related to the call center is as a result of the purchase. You know, looking to ‘07 we know don’t have any kind of a formalized plan from the standpoint of what we are thinking at this time. I wouldn’t be looking for any kind of material decrease in CapEx for the next year. I think that we have talked about plans to open a new fulfillment center, so that will certainly drive capital spending, we’ll continue to be investing from a technology standpoint. So I think around current levels, it’s reasonable thinking. You know, could be up a little bit, it could be down a little bit, that’s certainly what I would be thinking about for next year.

Shawn Milne - Friedman Billings Ramsey & Co.

Just as a follow up to that on the product development front, when you announced the Toys “R” Us you said the company was comfortable with $50 million plus and EBITDA for 70, do you still stand by that comment given your comments on product development spending?

Michael Conn

Yeah, absolutely.

Shawn Milne - Friedman Billings Ramsey & Co.

Okay, thanks.

Operator

Okay, and our next question comes from the line of Anthony Noto, please proceed.

Anthony Noto - Goldman Sachs

Thank you very much. I was wondering if you could comment Michael -- if you comment a little bit about the execution and the backbends the toy category obviously to the highly concentrated category during the Q4 and some of the prior sessions that have operated in the on line space -- successful in scaling so, may be you could comment a little bit on lessons learnt and how you’ve sort of preparing against that. And then secondly I know that you’ve integrated check out for some of your merchants, it appears that one of your merchants Levis had originally an announced holding. I was wondering if you could comment a little bit if you were satisfied with that product and if you are cannot be a source of incremental revenue given the uncertainties that they have, thank you?

Michael G. Rubin

Sure, let me in the first question as far as the Toys “R” Us play that goes in Q4, certainly Toys “R” Us has a seasonal business as any part that we have, If you look at the average business that they do its very significant, that is one of the decisions that drove us to open a second call center this year ahead of our expectations, also one of the reasons that we wanted to really from a technology perspective, bring a lot of extra capacity forward. I think really the lessons that we have learned is to have first and foremost a lot of good technology, customer service perspective, but also they have some extra capacity build, at the pace we grow, we continue to grow into what every capacity we add. So I think we feel really good that we’ve got a lot of additional capacity both from the customer service and a technology perspective and I think we feel that whatever capacity is extra this certainly we’ll grow into it next year so all we really do is bring it forward a bit. Certainly, one of the great things that we also feel today is having operated e-commerce business for a long time and pretty significant revenue. I think we also feel really good about the history that we have and the plan for the business and so far what we’ve seen is everything really going exactly as planned. The implementation for Toys “R” Us also I think could not have gone smoother during the second quarter and we did in compressed time period and again without any disruption, I guess our existing business, so I think some of the pain that we went through last year in some of the crunch time, adding other partners really helped us to do a much better job this year both in the implementation and for the planning for Q4. As we race to Google checkout I think at a macro level payments is an area that we feel really strongly about. We’re now working certainly with the four major credit cards, Visa, American Express and Discover but also with (inaudible) which provides financing also we were implementing PayPal also Google, we believe that having the broadest overall capability of checkout is something that is an important component of our platform, if certainly Google plays a role within that. As it relates to any specific partner, to be honest that in even -- I’m not even aware of the questions, yes I couldn’t give you a specific answer on that but I think we have 60 to 70 partners today and certainly a lot of partners at different components that we have within checkout and some people can add it, other people can deduct it and certainly that’s really a specific partner level but I cant give anything specific because I just don’t know about it on the one question yet.

Anthony Noto - Goldman Sachs

Great, just a quick follow-up, when do you think you will be breakeven on Toys “R” Us just given the seasonal nature and obviously you want to scale that business over time and make sure you make the right investment. My sense is you wont be profitable this year but not far from it, do you think it will be profitable by Q4 next year of somewhere?

Michael Conn

Yeah, I think in terms of from our contribution to EBIDTA perspective we would expect it to make a positive contribution to our EBIDTA this year and I think that you know as far as from a cash flow prospective it really just depends on how you allocate the infrastructure investments that we made and I think that you know, what Michael touched upon there is important in that it was -- you know, its Toys “R” Us that’s driven us to accelerate some capacity infrastructure investments but they are really to the benefit of the overall businesses, so depending upon how you look at those incremental investments would get you to you know, whether or not it was cash flow positive -- we are certainly looking at it being incremental positive you know, already towards this year and certainly more so next year.

Anthony Noto - Goldman Sachs

Great, thank you.

Operator

And our next question comes from the line of Aaron Kessler, please proceed.

Paul.J.Bieber - Piper Jaffray & Co.

Hi, this is Paul Bieber for Aaron, two quick questions. I was hoping that you could address supportive pricing trends in e-commerce and how that may impact gross margins going forward, and secondly a quick question on the balance sheet, the accounts receivable and payable seems to be high, is there anything unusual going on there?

Michael G. Rubin

Sure, pricing trends is always the --

Michael Conn

-- the pricing trend I think the business has always been competitive since we started, there has always been an environment for our partners that want to work with us to run a good process to get what we think is a fair win-win price. I think if anything, recently you’ve seen some prices go up as far as the cost of individual things that companies want to do on their own, so I think our pricing has been pretty consistent over the long term and there’s been a little bit of peaks and valleys and I think if anything we feel the cost that people doing what we can do for them on their own is increasing and I think we feel really good about where we are from a pricing perspective. The one change that you’ll see with our business is up until a few years ago, maybe two years ago we only did complete solution partners and today we do many different types of partnerships, take Toys “R” Us as an example, we provide the technology and customer service and order processing and all the marketing services for them but we do not provide any fulfillment. So the percent of what we receive will be much lower but the gross margins on that would be the same or similar to what we historically had.

Michael G. Rubin

And just about to your question AR is up I think $2 million or $3 million from Q2, one of the things we talked about that can lead to some volatility in AR quarter-to-quarter is group sales which is not a huge piece of our business but one of the only pieces of our business that we really generate any AR -- few days credit card receivables that are always sitting in our AR balance at the end of the quarter so that was kind of driving the $2 million or $3 million increase in some group sales activity. On the AP side from a sequential basis, a couple of things, inventory is up a little bit sequentially that’s driving a piece of it. Also a number of capital investments which are you know, committed and will report but not yet paid for so that’s showing up in the CapEx line next quarter but we are in house and so showing up in AP at the end of the quarter.

Paul.J.Bieber - Piper Jaffray & Co.

Okay thank you.

Operator

And our next question from the line of Colin Sebastian, please proceed.

Colin Sebastian--Lazard Capital Markets

Thanks for taking my call. I just wanted to draw in a little bit on the sales and marketing line, you indicated there was some efficiency you gained there in the quarter, I wondered if you can talk a little bit more about those and then comment on whether those efficiencies can be carried forward into later quarters I guess excluding the catalog expense. And then in terms of your backlog of new partners, the ones with enhancements, what’s your comfort level in getting this done ahead of a holidays and are there any launches -- are on the cusp for the year, thanks.

Michael Conn

Sure, on the sales and marketing expense, Colin, would say that you know, the efficiencies are really in you know, variable productivity both from a fulfillment and a call center basis. A part of which is driven by some of the technology investments that we’re making, a part which is just to benefit of getting larger and also just -- you know, the biggest driver is just a lot of hard work from the people in those facilities doing job finding efficiencies, its an opportunity that we think we very much can carry forward both this year and going forward I think that there is some times you will have a little bit of bouncing around so for example, in Q3 we will have a little bit of inefficiency if we’re bringing up a new call center but that should already be driving incremental efficiencies for us by Q4. We will experience the same thing a little bit next year to bring on the new fulfillment center. But in the fulfillment centers we’re bringing on next we see opportunities with going to a third quarter fulfillment center to gain significant efficiencies in terms of how we operate our business and optimizing, by category and by product type at an individual facility so, I think that from a variable operating efficiency perspective it’s a good story for us right now. And something that we think has a lot life force going forward.

Michael G. Rubin

To hit the other part of your question Colin, as relates to launches that are planned for the balance of the year, we’ve got the two really big launches kind of already under our belt which was Toys “R” Us and NFL. The NFL is actually launching a updated version of the site which we are going to be doing in the next few weeks which we are excited about looks great and I encourage you to look at but as far as additional sites there will only be a few more sites coming up this year -- small sites and we are totally comfortable with the timing of these launches. As it relates to other roadmap features we’ve rolled out several features already this year and we’ll continue to add several more features in front of Q4 we think they will, some of those will be very beneficial to the business and just some kind of on level -- we have really become a lot more predictable I think, last year we thought a little bit of pain by doing a lot at one time and also just so much growth in the technology organization, we are still going to have little bit of growing pain just because how fast the company is growing and just how big the technology organization is getting, I can say with a tremendous amount of confidence that the predictability out of our technology organization is vastly improved, is something that we are very comfortable with so, I have no concerns about on any of the significant initiatives that we have underway for this year and our ability to execute against them.

Colin Sebastian--Lazard Capital Markets

Okay great, and congratulations on the quarter.

Michael G. Rubin

Thank you.

Operator

Then our next question comes from the line of Scott Devitt, please proceed.

Scott Devitt - Stifel Nicolaus & Company, Inc.

Thank you guys, I appreciate the detail on the spending. I just had one question, as I am working through the guidance in the net revenues from product sales and I know Mike that you noted that some of the decline in the year-over-year rate is related to the non sporting goods category which I assume is the Palm deal and then to get to the full year guidance, there is a big year-over-year reacceleration at Q4, so I am just wondering if there is a product launch occurring with Palm or something else going on there? Thanks.

Michael Conn

I think that I wouldn’t want to comment on this, the partner by partner specifics, I think that the, there is as we look at the ups and downs within the business, lower expectations in the back half of the year that we previously had for that non-sports component product sales and as we look at the acceleration that we are expecting in Q4, I would say that’s largely driven by the sports component of products sales.

Scott Devitt - Stifel Nicolaus & Company, Inc.

Okay, thank you.

Operator

And our next question comes from the line of Mark May, please proceed.

Mark May - Needham & Company

Thanks for taking my questions. Just a follow up on the last question, is there any way if you -- maybe you could exclude the partner or partners in the other product category and kind of give us a sense of what your gross merchandise sales would be either in Q3 or may be the whole back half for the year, that the guidance would be excluding that partner. Second question, I know you have one unnamed partner that launches in the Q4, I’m wondering if you could give a sense of how large that partner is on a (inaudible) basis, either you know the range of what they did last year, the range of what they are expected to do this year?

Michael Conn

Sure, I think that this specifically quantify the effect of sort of the lower impact that -- of the lower non-sports product sales is a challenge, but certainly several points of growth is the impact of that so I think that, you know, certainly it does mask any underlying comp trends in the business. From a launch perspective back half there’s actually two unnamed partners of both of which we expect to launch in Q4, one to be late Q3 and the other is I think Q4, and that’s an unnamed partner that we previously announced and then today in the release we noted it also an unnamed health and beauty partner and those are both in the addition to the you know B2B that we announced yesterday. I would characterize those as average sized deals so I think that it’s just a fair way to think about it.

Mark May - Needham & Company

Just a follow up last question here on the marketing services efforts. Can you just help me understand sort of how you view the investments you are making there? Are they -- is what you are trying to do is build up on marketing group that can help you to drive GMS of your partner sites thus helping to drive your fee revenue or is it more about trying to directly drive sort of agency type revenue, I’m just trying to get a sense on what your -- what’s your goal with the marketing services.

Michael G. Rubin

Sure Mark that’s a great question and the answer is it’s really both and the reason is as follows. We think -- and we’ve already seen this in -- I think by the next call you’ll understand a lot more about what I’m trying to say right now but it is -- we’re just not comfortable just to specifically say that -- I think in the next, you know next call there could more information in the market place. So I think, what we are fighting is we can go a partner and not only provide them with all the infrastructure and expertise, but we can also now provide them with tremendous creative capabilities, tremendous online capabilities and tremendous email -- delivery capabilities and creative capabilities and the studios to go with that we we’re a lot more important to the partner. So one of the things that I’m seeing is multiple partners that are spending a lot of money with us and they really feel better about the relation with GSI as a result of spending that money with us and that’s a unique situation because when we see partners you say well, we knew that GSI had these capabilities and in a lot ways we developed capabilities for the first time, and partners are looking at us as a much more important strategic partner to them. So if you just think about where the world is going and kind of what it might look like in five years I think you will see. Our partners spend $2 billion to $3 billion in advertising today and that’s why our existing partners may -- I think its well over $3 billion and we believe a meaningful chunk of that is going to shift towards what the presence looks online and also marketing that online presence from -- though it used be traditional offline marketing dollars now be online marketing dollars. So, again we think that we can accomplish two things, one is to be strategically a lot more important to a partner by helping them with what’s very important to their long-term strategy and so we began to make a lot of money while doing it. One of the nuggets I’ll put up there today is just kind of trying to size up where we are and kind of where this is going. And last year we had well south of a million dollars in marketing and services as a brand new business I think this year in our first year in business I think we’ll have over $10 million in marketing and services is around $10 million the marketing services, so that can just give you an idea -- that’s you know pure server fees. And I think, you know long-term this can be you know well over a $50 million business in the next several years. So again we look at a business that can be highly profitable to GSI and how they are strategic in that the progress they work with us in this area think of us to the better and more important company to them.

Mark May - Needham & Company

Thanks.

Operator

And our next question comes from the line of Chad Bartley, please proceed.

Chad Bartley - Pacific Crest Securities

Hi, right thank you. Two quick questions first on Toys “R” Us follow up. I think you guys did too much of them in the first and second quarter. I am just curious how the revenue and expenses associated with that retreated, and may it’s in part -- deferred revenue seems it's like a business second quarter for us to balance there. And then in terms of your target of incremental EBIDTA margins, you guys talked about that in the past, just curious where that fits given some of the investment you are marking and do you think about the rest of this year may be? Thanks.

Michael Conn

Sure, I would say first -- you know, Toys “R” Us whether that factored into deferred revenue and is, you know we had a -- you know a number of things actually did factor into that, that was a component of it, and -- you know as we mentioned there is still implementation work -- represents you know some opportunity for us in the back half of the year as we complete the implementation work to bring some of the deferred revenue through to the bottom line. As it released to just overall view point on incremental profitability, I would say, as we look at sort of the potential of our overall operating model and I think there is, you know if anything we are becoming, you know more optimistic and if you think back to just, you know a little over year ago things like marketing services really work on the horizon of that the high margin low capital, you know business -- I thinks that, you know certainly you know still feels real good about, you know where we can get you from a model perspective clearly, you know we are investing, you know in the near term, you know some of the incremental values that were generating back in to the business so you’re not seeing as much of that flow through near term, but certainly seeing -- you know as much as that opportunity longer term.

Chad Bartley - Pacific Crest Securities

So I think you said 15% incremental EBIDTA margins kind of on a 12 month basis longer term, is that still a decent number to think about?

Michael Conn

Absolutely.

Chad Bartley - Pacific Crest Securities

Okay, thanks a lot.

Operator

And our next question comes from the line of Robert Peck, please proceed.

Robert Peck - Bear Stearns

Yeah -- hey guys, just a couple of quick questions here -- a bigger picture, you know Michael Conn, if you stopped growing tomorrow what sort of impact could we see on EBIDTA going forward and how you look -- when do you think GSI will be more of a free cash flow story, and at lastly, Mike Rubin, when you talk about $2 billion in merchandise sales goal. When do you sort of see achieving that?

Michael Conn

I guess first of all if we stop really tomorrow and I guess you can save my salary and Michael’s salary because I don’t think that we’d be exited enough to be here anymore, but I think in general that’s a fair question in terms of you know what is the underlying drag on the business from investments, from the cost of -- you know, upfront cost of bringing out partners. Its certainly substantial, I think its hard to get it, you know get an exact number although we certainly, you know look at you know, look at incremental investments in totally. I would say, you know at the very least, you know $20 million to $30 million, greater from a current standpoint and I think that one of the key reasons why you know instead of doing that much better today, you know we continue to invest incrementally as we thinks that number can be far greater that the $20 million - $30 million that we are experiencing now becomes what we can generate incrementally from investing now, but I think that it is certainly fair to look at GSI from a profitability standpoint as being understated in terms of what we can generate. You know, from a free cash perspective I think that you know, certainly this year is shaping up to be awash to even you know, a slight negative. I think if you looked at kind of where we were sort of ‘99 through 2003 aggregate well over $100 million of negative free cash flow, I think kind of ‘04 you know, thorough ‘06 or ‘07 you are looking at probably breakeven pretty cash on a kind of aggregate basis so I think that you know, we took five years where we used a lot of free cash kind of looking at next few years of roughly break even on aggregate basis, I think beyond that you know, we certainly think that we’re building the foundation to have a very substantial free cash generating characteristics for the business.

Michael G. Rubin

And to hit your last question as far as growing to $2 billion in NMF, I would say -- a very realistic timeframe.

Robert Peck - Bear Stearns

Thanks guys, great quarter.

Michael G. Rubin

Thanks.

Operator

And our next questions comes from the line of Jim Friedland, please proceed.

Jim Friedland - SG Cowen & Co.

Thanks, just a question on Toys “R” Us, now that Toys “R” Us will be basically a standalone business that you’re, can you give us a sense when it was an Amazon partner what percent of the traffic was coming from people who were trying in the amazon.com url versus people typing in either toysrus.com or just coming through the search channels, so to give -- to us an idea how long it could take to get that partner up to where it was or you know, even exceed where it was?

Michael G. Rubin

Sure, Jim, we’re really sensitive because our partners really want us to be about not discussing their data kind of information out for them such as a place that I am not comfortable with, the one thing that I will say that I don’t think in anyway would upset Toys “R” Us is that -- you know we look at that amount of money they spend in advertising and I think everyone knows its hundreds of millions of dollars and we believe that they unleash the integration that they are going to do going forward that customers will closely be educated about the Toys “R” Us and Babies "R" Us url’s being the place to go directly and I certainly believe and this is my personal opinion that Toys “R” Us has an opportunity to be one of the best multi-channel retailers in the country or really even in the world and I think they have got all assets today (inaudible) a long time to accomplish that.

Jim Friedland - SG Cowen & Co.

Okay, so then maybe is it safe to say or ask that the amount of money that Toys “R” Us is channeling into the online channel versus offline advertising is going to increase now that your working with them versus where they were before?

Michael G. Rubin

Yeah, again that’s just not -- it’s a great question and I am happy -- and we did announce that we are going to be -- Toys “R” Us have selected us to provide them with a bunch of marketing services of which one of them is placement (inaudible) I think on to the Amazon relationship might ensure that they did any but I wont want to get into any specifics, and that’s really a question I’d ask you to ask that.

Jim Friedland - SG Cowen & Co.

Okay, that will, fair enough, thanks.

Michael G. Rubin

Thank you.

Operator

And our next question comes from the line of Paul Keung, please proceed.

Paul keung - CIBC World Markets

Hi, Michael, Mike, good afternoon -- questions -- can I get one long term one, its more of an extension with -- earlier just one of the -- I’m going back about few years and you’ve been fairly consistent in staying about $1 to $2 million on to the new installation -- new customer and then your capex -- $1 to $2 million long term just investing in more infrastructure and into the platform and I guess to really start to drive the returns in capital at some point you want to scale you know, one of either of those two you know, one of those two lines and so I guess you mentioned free cash flow next year and you also mentioned earlier that your capital expenditures you expect to accelerate -- level so, when I do the math here I still find that you’re are you know, you are still spending roughly -- you know, $4 - $5 million per customer you know -- $3 to $5 million per customer a year. So it’s actually really hard to really leverage beyond those parameters so I’m just trying to understand what -- is there anything that I’m missing at the changing outlook.

Michael Conn

Yeah, no I mean I think first of all it’s a good perspective and I think that as we look at the business I think on the capital side I think from an infrastructure perspective, that’s certainly hard to leverage although we believe as we get larger the offering efficiencies of the facility that we operate -- gain significantly, so I think that’s a component that doesn’t tie in to the launch. I think the front end on the build cost is an area that we think that we can leverage substantially and it is you know something that is you know another area of investment so if we talk about -- when and Michael mentioned in his comments some of the -- the you know, projects that he had associated with the underlying architecture, they are related to development agility that related to lowering cost structure from a technology infrastructure going forward, I think that really hit that I believe that there is quite a bit that we can do on that large cost from a technology perspective. And I don’t think its anything that you see in the immediate term but I think that is something we certainly believe is very cheap for the operating cost.

Paul keung - CIBC World Markets

Okay and I know some of the leverage you’re getting on the sales and marketing line, does your guidance reflect that continued leverage of $1 million spend -- campaign?

Michael G. Rubin

Yeah, I think that certainly you know, some of that’s reflected if you look at Q2 we did better than we though that we would do within that area, I think that there is that potential again but and I think you know, our guidance certainly does reflect you know, some continued year-over-year operating efficiency which is something that we’ve seen historically and that we would always certainly expect to see some movement -- you know, as far as you know, if we continue to do better than we planned, that would certainly represent opportunity for us.

Paul keung - CIBC World Markets

Okay, and the last question. You highlighted the marketing service a bit, I was wondering when you look at that, is that -- looking at the landscape it’s still a very fragmented and competitive business, is that an area and where you see opportunities in the standpoint of consolidation or are there things that you need to do to sort of differentiate on what is today still very fragmented?

Michael Conn

Sure. I think that -- I’ll never say never and certainly we’ve made a few acquisitions, we believe we have the capability and people and ability and knowledge at GSI that we can grow much of that ourselves, we certainly believe that we have a significant competitive advantage over any of the other companies in the department that work with us which is our primary target or really -- target has an integrated relation with GSI already so by working with GSI in the different marketing services and having GSI -- business puts us in a much better position to deliver far more value than what any of the other competitors could do on their own.

Paul Keung - CIBC World Markets

Okay, thanks a lot.

Operator

[Operator instruction]. There does not appear to be any additional questions at this time, sir.

Michael G. Rubin

Okay, we thank everybody for joining us and we’ll talk to you next quarter.

Operator

Ladies and gentlemen thank you for your participation in today’s conference call, this does conclude the presentation and you may now disconnect.

Copyright policy: All transcripts on this site are the copyright of Seeking Alpha. However, we view them as an important resource for bloggers and journalists, and are excited to contribute to the democratization of financial information on the Internet. (Until now investors have had to pay thousands of dollars in subscription fees for transcripts.) So our reproduction policy is as follows: You may quote up to 400 words of any transcript on the condition that you attribute the transcript to Seeking Alpha and either link to the original transcript or to www.SeekingAlpha.com. All other use is prohibited.

THE INFORMATION CONTAINED HERE IS A TEXTUAL REPRESENTATION OF THE APPLICABLE COMPANY'S CONFERENCE CALL, CONFERENCE PRESENTATION OR OTHER AUDIO PRESENTATION, AND WHILE EFFORTS ARE MADE TO PROVIDE AN ACCURATE TRANSCRIPTION, THERE MAY BE MATERIAL ERRORS, OMISSIONS, OR INACCURACIES IN THE REPORTING OF THE SUBSTANCE OF THE AUDIO PRESENTATIONS. IN NO WAY DOES SEEKING ALPHA ASSUME ANY RESPONSIBILITY FOR ANY INVESTMENT OR OTHER DECISIONS MADE BASED UPON THE INFORMATION PROVIDED ON THIS WEB SITE OR IN ANY TRANSCRIPT. USERS ARE ADVISED TO REVIEW THE APPLICABLE COMPANY'S AUDIO PRESENTATION ITSELF AND THE APPLICABLE COMPANY'S SEC FILINGS BEFORE MAKING ANY INVESTMENT OR OTHER DECISIONS.

If you have any additional questions about our online transcripts, please contact us at: transcripts@seekingalpha.com. Thank you!

Source: GSI Commerce Q2 2006 Earnings Conference Call Transcript (GSIC)
This Transcript
All Transcripts