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GSI Commerce, Inc. (GSIC)

Q3 2006 Earnings Call

October 25, 2006 4:45 pm ET

Executives

Michael Conn - CFO

Michael Rubin - Chairman and CEO

Analysts

Anthony Noto - Goldman Sachs

Victor Anthony - Bear Stearns

Scott Devitt - Stifel Nicholaus

Paul Keung - CIBC World Markets

Jim Friedland - Cowen and Company

Colin Sebastian - Lazard Capital

Christa Quarles of Thomas Weisel

Aaron Kessler - Piper Jaffray

Chad Bartley - Pacific Crest

Presentation

Operator

Good day ladies and gentlemen. Welcome to the GSI Commerce Third Quarter 2006 Earnings Conference Call. My name is Stephen and I will be your coordinator for today. (Operator Instructions). I'd now like to turn the presentation over to Michael Conn, Chief Financial Officer.

Michael Conn

Thank you and good afternoon everyone. Welcome to the GSI conference call for the third fiscal quarter ended September 30, 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, including adjusted EBITDA and merchandise sales and certain ratios that use these measures. In our Form 8-K, which can be accessed through the Investors section of corporate website at gsicommerce.com, 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 delivered strong results in the third quarter with revenue ahead of our expectations and are smaller than planned net loss. Net revenue on a GAAP basis for the quarter was up 40% versus last year. Non-GAAP merchandise sales or total transaction volume through our platform increased 84% versus last year. This is the largest percentage growth in merchandise sales we have delivered since the third quarter of 2004.

Sales were strong throughout the quarter and we saw some earlier than normal holiday oriented purchases. Sales trends were boosted on a sequential basis by the launch of Toys "R" Us and Babies "R" Us on our platform, which actually occurred in the last day of the second quarter. Overall our merchandise sales growth again reflected strong comp store trends and solid contribution from new store that were not in our platform for the entirety of the third quarter of fiscal 2005.

From a category standpoint, our three largest merchandise sales categories for the quarter were sporting goods, toys and apparel. And our three fastest growing merchandise categories for categories that were in for at least one year were health and beauty, apparel and sporting goods.

Sporting goods represented 30% of merchandise sales in the quarter compared to 37% last year, which was the lowest percentage of merchandise sales in the quarter ever represented by sports. Despite declining as a percentage of total merchandise sales, sporting goods experienced impressive 51% growth versus last year's third 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 and our top five partners represented 48% of merchandise sales in the third quarter compared to 58% in the third quarter of last year. Our largest partner accounted for 18% of third quarter merchandise sales this year compared to our largest partner representing 20% of third quarter merchandise sales last year.

Product sales represented 36% of merchandise sales in 3Q this year compared to 54% in Q3 of last year. On a trailing 12-month basis, total merchandise sales surpassed $900 million and net revenue surpassed $500 million.

Our gross margins in the quarter improved 840 basis points in last year, driven by 220 basis point improvement in product margins and more than 100% growth in service fees. The improvement in product margins resulted primarily from a favorable mix shift between sporting goods and electronics and higher realized gross margins in sporting goods and electronics.

Service fee growth which was above 100% for the first time since the fourth quarter of 2004 was driven by comp and non-comp transaction fees, continued strong performance from marketing services and technology fees related partner website enhancements and launches. Sales and marketing expense exclusive of stock-based compensation increased 58% in the quarter versus last year as variable expenses including fulfillment, customer service, revenue share for owned inventory deals and order processing increased due to higher volume, although we continue to be pleased with the level of variable productivity improvements that we are achieving. We also increased catalog costs due to the roll out of the NFL catalog. Keep in mind the NFL was not a partner a year ago.

Product development expenses were up significantly on a year-over-year basis and sequentially as we continued to invest in our technology platform. In addition certain expenses that had been deferred in prior periods were recognized as we completed specific projects. Based on the strong volume trends we experienced during the quarter, we did spend incrementally in our technology compared to our original plan for the quarter as we had previously communicated we will look to do.

Year-over-year growth in G&A expense reflected the overall growth of our business as well as expense related to the retirement of Bob Blyskal as our President and Chief Operating Officer. As part of our quarterly results, we then recorded a charge related to our investment in Odimo Incorporated this time for approximately $737,000. Odimo was 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 loss on investment is non-cash and is not something that we view as reflective of our operating trends. The carrying value of the investment was approximately $140,000 at the end of the quarter.

Overall, adjusted EBITDA was $1.4 million compared to adjusted or breakeven last year. Net loss for the quarter including the $737,000 Odimo charge and about $700,000 related to retirement expenses related to our former President And Chief Operating Officer was $6.2 million versus a net loss of $5.4 million last year.

Looking at our balance sheet on a year-over-year basis, cash and marketable securities declined $8 million from $112 million to $104 million.. Inventory increased versus last year in anticipation of the holiday season as well as in advance of the NFL season. We mentioned in our second quarter conference call that we expected to see inventory increase this period.

In addition at the end of the quarter, we completed a transaction in which we purchased the remaining minority interest of a joint venture with a subsidiary of Simon Property Group for $3.2 million. The joint venture was created in 2003 and controlled certain of the company's contracts in the apparel category.

Finally let me quickly comment on guidance. Our view for the year is relatively in line with our prior outlook with net revenue in merchandise sales increased to reflect the upside in 3Q. We also increased the line of our adjusted EBITDA and net income ranges. Net income guidance for the year includes $2.8 million of charges related to one-time investment for Odimo as well as the $700,000 related to the retirement of the company's former President and Chief Operating Officer.

With that, let me turn it over to our CEO, Michael Rubin.

Michael Rubin

Thank you, Mike. I am pleased with the results for the third quarter. Our performance exceeds the high end of our guidance for net revenue, merchandise sales, adjusted EBITDA and net loss. The $233 million that we generated in the third quarter merchandise sales was an increase of 84% over last year. We exceeded the high end of our net revenue guidance by $8.5 million and the high end of our adjusted EBITDA guidance by $1.7 million. We also beat our net loss guidance by approximately $660,000 even as we took combined charge of approximately $1.5 million related to the investment in Odimo and for an executive retirement.

In addition to our financial results, our contracts during the quarter and through the beginning of October were highlighted by several partners signing contract extensions with us including PBS, Nickelodeon, Palm and Rockport. I believe that the renewals and expansions of these existing deals is evidence of the value that we provide to our partners.

Since our last call, the company signed two new partners, one in sporting goods and one in baby products. The new partner in baby products is the first e-customer partner for which GSI Commerce is only providing order processing, fulfillment and customer care services. This is significant -- this is significant and that marks the first time GSI has integrated its fulfillment and customer service operations with a partners technology solution. Our strategy has evolved so that we evaluate the specific needs of a particular partner and sell our solution that fits the partner's needs. We believe that each component of our platform is world class and capable of staying on its own thus where our key differentiator is the breadth of our offering but unbundling our platform we increased the use of our potential prospects which should enable us to add more deals over time, which in turn should generate greater revenue from each partner component and create cross sell opportunities.

To date we've signed nine new partners for fiscal year 2006, which meets the high end of our goal of signing between 5 and 10 new partners this year. Of the nine, eight are domestic and one is both domestic and international. Four partners have launched including the NFL, Toys "R" Us, Dockers and Iomega. One additional partner, which is our new baby products partner is scheduled to launch during the fourth quarter. The remaining four partners, BCBG Max Azria and an unnamed apparel partner and an unnamed cosmetics and fragrance partner and an unnamed sporting goods partner are all scheduled to go live in early 2007.

In addition to the nine, one of our existing international and domestic partners is scheduled to launch their US e-commerce business later this year. The unnamed apparel and unnamed cosmetics and fragrance partners were recently scheduled to go live in late 2006 but in both cases we have agreed with the partner's decision to launch early next year. These change will not have a material impact on our results.

On our last quarter's call I mentioned that we were close to adding a second customer care center to help us add capacity and backup redundancy to our customer care facility in Melbourne, Florida. Last week, we opened a new 48,000 square foot call center in Eau Claire, Wisconsin.

In September, we entered an agreement to purchase the facility and we expect to receive approximately 4.5 million in tax, forgivable loans and training subsidies from various Wisconsin state and local economic development agencies. The purchase is expected to close in the fourth quarter of this year. During our peak fourth quarter, we anticipate the new call center will employ between 400 and 450 people. I've also mentioned that it was our intention to add a new primary fulfillment center during 2007. And last week we signed a new lease for a new facility in Richwood, Kentucky. Richwood is located about 10 miles south of Cincinnati and about 80 miles from our facilities in Louisville, and Shepherdsville, Kentucky. We expected to open up the facility sometime late in the second quarter or early in the third quarter of 2007. The facility will provide us with additional 540,000 square feet of space. It will be our most automated facility with our fulfillment operations. When this new fulfillment center opens, our fulfillment platform will include owned or leased space of approximately 1.7 million square feet and will include three primary fulfillment centers and two smaller owned facilities.

Over the course of the new -- over the course of the last quarterly calls, I've talked about the investments we continue to make in our business so we are better able to tackle the growth opportunities we believe are front of us. A recent example of how this investment plays out was the third quarter unveiling of a totally revamped and redesigned web store for Dick's Sporting Goods. As you are aware, we've been growing expertise and capabilities of our marketing and design services group. This year that group pitched and secured a complete web store redesign project for Dick's Sporting Goods. The new web store highlights store-within-a-store shopping which parallels to in-store experience and caters to specialized interest such as golf, team sports, hunting, fishing and other outdoor activities. The redesign add a powerful parametric search and navigation features and the site's visual merchandiser was enhanced through the use of dynamic rich media. Launched on time in July, the newly redesigned on-line store provide Dick's Sporting Goods with a new state-of-the-art online shopping experience for the customers while reinforcing the quality and authenticity of the Dick's Sporting Goods brand online.

It's important to understand that the marketing dollars that Dick's Sporting Goods may have targeted and spent for other purposes were directed to this project which we believe is a sustainable growth trend among most retailers. Further, we also believe that this channel shift of marketing dollars from traditional media to the online forum is a realization by retailers that the web source are fast becoming the greatest marketing vehicle that they have to their brand. We believe the shift also includes an investment in new Web 2.0 technologies such as AJAX and Flash applications that enrich the on-line shopping experience and bring consumers closer to the retailers brand.

A good example of that is work we recently completed with Dick's Sporting Goods to build online bragging boards where visitors to their web store are provided the opportunity to show off the results of their hunting and fishing adventures. These bragging boards built with Web 2.0 technologies help connect outdoor enthusiasts to Dick's Sporting Goods brands. Our investment helped us build our expertise across all aspects of the e-commerce value chain. There was some proof of this claim demonstrated recently when Internet Retailer published its Top 500 guide profound of 500 largest retail websites in the United States. Out of all the service and application projects in the industry, GSI Commerce ranked as either the leading provider or the runner up in 6 of 16 e-commerce categories based on use among the top 500 online retailers. No other application service provider was listed more than three times across any of these categories.

Further, in August we held our second annual partner summit with several other partners talked about the roadmap initiatives GSI implemented together with their teams during 2005 and early 2006 to enhance the businesses. We are one of the top fashion of power brands in the world to tell us how our new content management system will make it easier and faster for them to change our content and images for more than 600 pages a year on the web store. We heard a mall based apparel and accessory retailer tell how the implementation of our new Express Shop feature allowed for easier browsing of multiple styles within a family of products, faster browsing of colors and size choices and how it reduced the number of clicks to get the checkout.

We heard a professional sports league tell us about how the collaboration with GSI on a 3-hour sale resulted in a estimated 400% incremental sales gain for the entire day and so the conversion rates ballooned up 150%. Since then, we've had several other partners took advantage of time-based sales promotions. We heard a national home category retailer tell us how their buy, online and pickup in store program was demonstrating high double digit growth for 2006 and how the statistics were also showing the customers using the buy online, pickup in store feature were more apt to buy additional products once they arrive in a store. We have now three partners using our buy online, pickup in store feature and we expect other partners to deploy this in the next year.

We heard a national consumer electronics retailer say they had never learnt so much about the product line until the parametric search and navigation feature. They said this feature makes it easier and quicker for customers to get to products and allow the retailers to better define this product attributes, which helps with the content creation and quality assurance. Search is an another example where GSI continues to invest in the platform that our partners would find difficult to accomplish on their own.

We heard another national power brands claim about AB testing provided on the GSI platform through our integration with the third party provider, will have the retailer to make better merchandising decision based on empirical data rather than simply gut feel.

Additional part of presentation explain the importance of incorporating product customization about how implementing a micro site within a web store could increase sales and attract new demographics and about how catalog program can be an important part of the growing multi channel strategy several of our partners are experiencing. This year we will manage catalogs for 6 of our partners.

Overall the partner summit is turning into a great annual event and we believe it's unique in e-commerce industry as some of our largest brands and retailers are brought together to participate in a forum where they have an opportunity to share ideas, experiences and talk about how to grow the business. They are marking each other and we're marking them. There's another way in which GSI provides additional value to our partners.

In additional, I'd like to point out another trend which we believe is becoming important in the industry, the personalization of customization of products on-line. We recently hired a VP of personalization to oversee a new personalization operation in our Louisville fulfillment center, which we expect will cometh a growing demand for this process from our partners.

For example, the NFL has moved its entire personalized jersey operation to us. That's about 150,000 jerseys we'll personalize for customers of the NFL in the upcoming season.. Again, as we grow and invest in our business, this is another value added capability that we've added to our platform to help grow our partners' businesses.

In a recently published report, Forrester Research points out that the next decade is an opportunity for companies to cater to margin driving customers and to cultivate the characteristics that attract them. The investments we make to build and enhance our e-commerce offering are made with an intention that we will help our partners respond to exactly this type of challenges. Our investments advance our partners e-commerce sites, which in turn help them grow their e-commerce business faster and more profitability to make and do on their own. This is important to our success today and will be at least as important to us as we look to capitalize on the continued growth of online shopping. According to Forrester, a recent five-year forecast of US e-commerce industry, online retail excluding travel will continue to experience double-digit growth in the near term with e-commerce business to consumer sales expecting to grow from $132 billion in 2006 to more than $270 billion by 2011, which is a percentage of total retail sales, which grow from 6% today to 9% in 2011. In the same report. Forrester notes that consumers in North America now spend more time with their PCs then they do watch on TV, listen to the radio or reading magazine combined. That is incredible pronouncement, but all the more reason why we believe that marketing benefits of the on-line channel has huge potential and why we believe it is important for us to continue to invest in the capabilities to help our partners address the channel shift.

With solid momentum in our business and the e-commerce industry in general, we are looking forward to the upcoming holiday season and the continued growth for our company. With that, let us take questions.

Question-and-Answer Session

Operator

(Operator Instructions). And our first question comes from Anthony Noto of Goldman Sachs.

Anthony Noto - Goldman Sachs

Thank you very much. I was wondering, Michael, if you could comment on the partners that you re-signed. Were there economic relationships with those partners improve the same or were there some new difference on the downside? And then separately you talk about seeing new partner issues. Have you lost any partners that have not renewed in the last 12 to 18 months? And then I have one follow-up. Thanks.

Michael Rubin

Sure. As far as economics go for the four partners that we extended in the third quarter, there was really no change of any materiality to the economics. There's always things that you learn once you're in a partnerships for multiple years and you may tweak a deal but really there was really no change to the economics overall. As far as -- any partners that we've lost in the last 12 to 18 months, we've lost no partners of significance. I think many people know it has been our strategy to not renew some really slop partners that we brought on in 1999, 2000, 2001 period, partners that represented literally a few hundred thousand dollars of businesses. So those have been the only type of partners that we haven't renewed. There's been no partner I think since a few years ago that we have not moved forward that's represented more than -- less than 1% of sales.

Anthony Noto - Goldman Sachs

I was wondering if you could also just comment as you think about 2007 from an international perspective. Will you set in stone what you want to try to drive from a new partner relationship internationally in 2007? And then your unnamed health and beauty partner expected to launch in the fourth quarter is still on track, I'm not sure if you have mentioned that. Thanks.

Michael Rubin

Sure. As far as international goes, we consider it to be a critical part of our long-term strategy. And we continue, I think, you know, we made our first step international when we bought a company earlier this year in Barcelona, Spain and we continue to grow internationally. So we certainly think it's going to become a bigger part of our business and we certainly believe that we are going to have several of our existing brands move internationally with us. And that's really the biggest goal we had internationally, which is really to take the existing brands that we had that had big international businesses and work with them to grow internationally. So that's where I think the growth is going to come from and we think it represents a big opportunity for us.

As it relates to the second part of your question, we regarded in one fragrance partner, I did note in my prepared remarks that we had two partners that we had initially planned on launching in late 2006, but we’re now going to be launching in early '07 and that is one of the two partners, and really the reason for that is just incremental scope increase, which ultimately leads to a big and better business, where we mutually move with the partner that we were going to push it off and it really has no -- really, no material financial impact to us. But really is in the mutual best interests because if a partner wants to do more and add more features and functions and spend more money, is out with the business with us, we’re always interested in doing that.

Anthony Noto - Goldman Sachs

Great. Thank you very much.

Michael Rubin

Thank you.

Operator

Our next question is from Robert Peck of Bear Stearns.

Victor Anthony - Bear Stearns

Hi, this is actually Victor Anthony in for Bob. Just two quick questions. First of all congratulations on a good quarter. The first question is what would the year-over-year revenue growth excluded the new stores in our platform such as NFL, Dockers, Toys, and Babies "R" Us, kind of like a same-store sales growth number that you're looking for. And the second quarter is when we matched up the mid point of the EBITDA guidance for the fourth quarter, against the mid point of the revenue guidance if someone implied that the incremental margins where from a modest, or at least lower then what we’re expecting. Looks like you guys are absolutely baking into additional costs for the quarter, kind of curious, what are those costs, and how much of those costs actually due to the Toys "R" Us contract. And if you could just give some update on the progression of the Toys “R” Us integration? Thanks.

Michael Rubin

Sure. I think on the year-over-year comp, its not a number we've broken out specifically. I think in general what we did say was that we did experience strong comp growth during the quarter. I think it's kind of a sort of rule of thumb. What we've just agreed that is, comps have usually, roughly approximate overall industry growth or e-commerce growth which I think has been in the upper teens to low 20s and I think that’s reasonable proxy for the type of comp store momentum that we see within our business, and when you get through the individual partner basis, it ends up being a lot more widespread with many, you know, well above that, some below that, a lot of that driven by, you know, the specifics to the individual partners business. But overall, we would characterize those trends as healthy without specifically breaking out the number there. If you look at 4Q I think if you think about how we've really managed the business this year, we've been focused on the overall annual goals for profitability for the business, and where we've seen opportunities to continue to be on track to achieve those goals, and at the same time invest incrementally. We have invested incrementally really driven by the fact that we're seeing tremendous growth opportunities in the marketplace. So I think we've had the discipline to maintain on track to achieve profitability, but where we’ve seen opportunities we have invested incrementally. So with the momentum in the business in Q3, we did spend some in the quarter incrementally, and some of that close through to 4Q. So, I think you're right in picking up that there is some incremental spending. They're not huge dollars, but certainly offsetting some of the upside that we’re seeing on the revenue side, though getting us position to hit. Overall, goals for the year. Actually if you look at the low end of our guidance, you know, we have raised it consistently through the end of the year. We are now at a range, and that's something that we feel good about. As far as looking at the incremental spend, we're not going to break out on a per partner basis. Certainly, you know, Toys “R” Us is as we've mentioned our largest partner. So it is certainly driving a lot of growth for us, and as a factor, as we've mentioned in the incremental spending, but wouldn't breakout a specific number there. And then, I think lastly, you know, Toys “R” Us, I'll let Michael comment on that.

Michael Conn

Sure. I think as far as the Toys “R” Us integration goes, its something that we’re very, very pleased with. I'm really proud of the organization on really what we accomplished. One of the things that was very unique about Toys “R” Us is we really had 90 days to build the entire Phase I of the site, and that is quicker than we would normally build a site. And also for our business, its, you know, much bigger than the average, so, we successfully accomplish that. We launched on-time on June 30th or July 1st. And feel really good about what we’ve accomplished so far. Another thing that I think is really important to look at is we did that without disrupting any of our other existing partners. We're really able to do that, and service our existing partners at the same time. We had since we' launched a site continue to roll out features, I think we maybe even rolled out an additional 81, or, I only heard this number a few days ago. But I think we brought out additional 80 features since June 1st on the site, and I think its really excited that now represents the Toys “R” Us and Babies “R” Us brand very well. So, we feel really good about it. We think the relationship is strong, and we're proud of what the organization has accomplished.

Victor Anthony - Bear Stearns

Thanks.

Operator

Our next question is from Scott Devitt with Stifel Nicholaus.

Scott Devitt - Stifel Nicholaus

Hey guys. Thank you. First question on the NFL deal, I was wondering if you could give us some idea of the percentage of revenue that actually comes in 4Q for that business? And then separately on the NFL, the catalogs that you're sending out, how many did you send out, how often do you send them, is it only in-season? And then what exactly was the dollar impact within the third quarter sales and marketing line? And then had a couple of follow-ups, thanks.

Michael Rubin

Sure. I think on the percentage of business, I mean, wee work out with specific seasonality with our partner. I can say just in general, with NFL, I am really driven just by the -- when the season occurs, it is, you know, for GSI, which already has a highly seasonal business, NFL is even more seasonal. So I think, you know, directionally that would indicate higher percentage than normal in the fourth quarter. The catalog is mailed only during the season. It's pretty much monthly for over a five-month period time. I think we'll mail in the neighborhood of 10 million catalogs this year. The impact in the quarter was probably, I think, in the million dollar neighborhood. Some of those expenses are incurred during the quarter, but there is also amortization of certain catalog expenses that bring some of that expense into the fourth quarter plus the most the heaviest amount of mailings occur during the fourth quarter. So, it's more of a 4Q expense but you also have a better matching of expensive in revenue in 4Q, about a million dollar impact in 3Q.

Scott Devitt - Stifel Nicholaus

Okay, thanks. And Michael, you mentioned unbundling in this new baby products customer where you're just doing order processing, fulfillment and customer care. And I'm wondering should we expect smaller deals in the future in 2007 and more unbundling to occur? And you know will this cause an increase in the sales force as well in the future?

Michael Rubin

Sure. That's a yes and no answer to that question. I think as far as smaller deals go, the answer is no. As far as more unbundling deals goes, the answer is yes. We've got through an incredible evolution from when we start the business. If I think back to 1999-2000, we kind a sold one business by which was -- we took over your business and paid you a royalty did everything for. It's kind of the traditional licensing model. We did that really for the first couple of years and then we evolved, I guess, by 2001 to selling a full service solution but the partner who could own the inventory, could sign to us and we charge them a commission. And we did that for the next couple of years when we had two business models. By 2003, 2004, we realized that we need to had a wider offering. We started to lap it through by technology with technology on its own or technology with fulfillment, and technology with customer service, but not have to buy the complete solution. It really the realization that we've come to; is what's most important to us, is to get in business with the best brands, companies that we think have tremendous ecommerce opportunities and we need to make our offer more modular. So if somebody wants to come in as a great brand they want to use us for the subset of what we do and that’s the way for us to start doing business for them, we're very excited about that opportunity.

And I think finally we have the offering right and we're -- if it's the right partner and that's why the deals won't get smaller from a partner despite the risk. The right partner were going to be completely modular and then buy what they want from us. That's not going to change. The life of terms of deals that we work with that's not going to change, again I think the quality partners for kind of our enterprise type offering. As it relates to the sales force, we have had a sales investment that has been fairly steady over the last several years and the biggest reason for that was because we had really a capacity constraint that we couldn't add more partners than we've done historically. We think there's an opportunity for us in the future, just start to add more partners than we had historically and we had begun this year to invest more in the sales organization and I think that's one of the incremental investments that you are seeing being to happen in Q3 and Q4 and we plan to do more of next year that's really because our opportunity is bigger, we can sell this to more companies and they're a great brands and I think the offerings are being really well received. So definitely we do expect to spend more money in the sales organization, get a great return from that going forward.

Scott Devitt - Stifel Nicholaus

And then finally could you update us on Google Checkout, how that integration is working and any thoughts on PayPal as well? Thanks.

Michael Rubin

Sure, as it relates to Google Checkout, we were I think one of the earliest adopters of Google Checkout. And we launched with this -- when they launched with that I believe June 1st or July 1st, we've seen very positive results with Google Checkout. We've seen high partner adoption on Google Checkout. I think today we have 15 or 20 partners that have adopted Google Checkout. And these are some of the biggest partners using that. I think we've got to double the amount of partners today using Google Checkout when we initially launch July 1st. So all it all, this will definitely gain a lot of attraction for us and I think our partners are pretty excited about it. If you take a step up to the macro environment, we believe in accepting all payment methods, payment types, terms etc. is very important to us. So, we now work with Bill Me Later for financing. We are working with Google for their Checkout, we now accept multiple gift cards -- multiple gift cards in one Checkout process. If someone spent 100 bucks, then one use four $25 gift cards that's something else we do. We're going to start to take PayPal in the fourth quarter. And all in all we believe that GSI probably has the widest amount of different checkout of payment methods possible and we believe this is really another reason some are partners with us. If you went out to do this on your own, it would be on highly complex to do each of these integration one at one time and we believe all these are working. I think they represent nice single-digit percentage of sales each and in aggregate mean a nice double-digit percentage of sales, we definitely have to withdraw them.

Scott Devitt - Stifel Nicholaus

Thank you.

Operator

Our next question is from Paul Keung of CIBC World Markets.

Paul Keung - CIBC World Markets

Thank you. Michael and Michael, good afternoon. As I wondered -- I was interested in your comments you made earlier that you made about the partner summit and I guess some of the targets made on marketing services and what I am looking to is we kind of go back to some of your comments the last couple of years, what you focus upon. A lot of the challenges in the past have been trying to manage the new partner growth and its look like there may be some of the newer challenges ahead have to do managing I guess horizontally in selling services across the closet but partner base. So Mike, my question really more is -- have you really changed the way you've measured productivity ROI across your platform? And do you still – I guess across civilization by customer by service and what I am trying to get at ultimately is, what are the implications do you kind of return and how do you think about that?

Michael Rubin

That's a very good question. And it's probably actually the first time we have been asked -- personally I have been asked that question. The answer is there are definitely complexities associated with due to lot more of partners. I think to date we've done a okay job in if you look at all the opportunities we have and just go through the spectrum of different things and (inaudible) new partner and then you look at those against our adjusting partners, I think we've done okay. We haven't done poorly, but we haven't done great. I think going forward the opportunity to penetrate our existing partners in a much deeper fashion. Is one of the biggest opportunities that GSI has, it's something they are really excited about. So I think you will see us enhanced this week the way that we run the business to make sure that we are fully maximizing the opportunities with our partners, the thing that I will tell you that probably gives me a tremendous amount of excitement about where we are. If you relocate the great partners, of that today roughly 60 partners that we have this long-term exclusive remiss with these partners and then today without penetrating them near as well as I believe we will over time. Take on top of that the great macro trends of on-line marketing dollars, shifting online companies really want to invest in their on-line presences and what that means. I think GSIC become even more important to our partners than we are today over time and you can see us do a lot more with our partners and that will be our most profitable business because this with our existing partners we are looking to make some most money and by the way, all of these incremental things will make the base business that much more profitable as well.

Paul Keung - CIBC World Markets

Okay interesting. And I guess my second question, kind of assets coming out of Amazon, I think one of the interesting comments I heard coming out of them as it relates to you is that they've increased basically [with toy] and selection fairly aggressive for this year, of course a number of reasons, and I guess that sort of has an impact on – overall productivity in your cost structure and so -- from a competitor stand point have you seen a lot of your partners do the same thing? And to what extent is that -- how that flows through from impact in productivity that you have on your fulfillment side your business?

Michael Conn

Sure I think that assortment expansion is a lever that many partners should continue to use and really should use. I think what Amazon is doing is smart. I think what you've seen with our partners is, a, they've had a very wide assortment and b, they're going to continue to expand their assortment over time. I think what is important to note is that the efficiencies that we get in operating our infrastructure every year are much greater than any inefficiencies you may get from assortment expenses, if I would look at our productivity our cost per unit, cost per contact year over year we have significant efficiencies that we're gaining each year. So, even with the expansion of assortment, we're certainly more -- we are gaining efficiencies at much quicker pace.

Paul Keung - CIBC World Markets

Okay great. Thank you very much.

Michael Rubin

Thank you.

Operator

Our next question is from Jim Friedland of Cowen and Company.

Jim Friedland - Cowen and Company

Thanks. Just wanted to get a little bit more inflow on the increase in the product development line in terms of how much of the expenses in the quarter were just one-time and as you think about that line going into '07, I know you're not ready to give full year guidance yet but just trending, given all the things that you've just talked about on this call, is this going to be another year where we see a big ramp there, I mean, could that line grow faster than the net revenue line or just given that you're starting to see some scale in the general business, should you start to see some leverage there?

Michael Rubin

So, I think a couple of things. I mean, there was some amount of the product development sequential growth in the quarter recognizing some deferred expenses that were recognized when we completed projects. So I think that there's certainly one way to look at it that as one timer, but the flip side of that is that's really a growing part of our overall business that is beyond just the transaction fees that we really have a growing project oriented business. So I think that you will see some continuation of that. The offset of that is the strength in service fees and the strength in gross margins that you see as a result of it. The other thing that you just also saw in terms of sequential growth in product development expenses during the quarter is we were really ramping throughout second quarter and we have the full quarter, in effect to that the third quarter and then continue to ramp throughout the third quarter, so you really have that. All that being said, I think there was a little bit more of the recognition of expenses in the third quarter that is representative of our underlying trends. So, sequentially as you probably see expenses, you know, flat to down in the fourth quarter. And I think that this overall level is you know roughly indicative of kind of our current run rate. So that would have us up year-over-year next year but I think not to the extent that you've seen in the third quarter both sequentially and year-over-year. So I think again expect to continue to be spending aggressively in this area, expected to be continuing to grow strongly, but I think third quarter made it look a little bit greater what the true underlying trend is.

Jim Friedland - Cowen and Company

Okay, great. And then, just one other thing, on your general long-term guidance of five to ten partners a year, it sounds like they've done what you said that ten partners a year, it sounds like they've done what you said that you continue to feel comfortable with that trend continuing into the future?

Michael Rubin

I think we definitely feel that we'll continue that trend and I think we think over time that could start to slowly increase. I mean we want to grow in a smart way, want to make sure that we handle all of our existing partners well but at the same time, we're investing in all areas of the business to be able to over time and slowly increase that beyond the 5% of the currently due per year.

Jim Friedland - Cowen and Company

Okay, great. Thanks.

Operator

Our next question is from Colin Sebastian of Lazard Capital.

Colin Sebastian - Lazard Capital

Thanks and congratulations on the quarter. One question a follow-up on the unbundling. It sounds like the baby products contracts and perhaps some other new partners going forward won't be utilizing the technology platform or at least utilized as your existing partner base does, so I guess, I'm wondering how the economics of those partner deals might change as a result? And a couple of follow-ups, thanks.

Michael Rubin

Sure, I think that the amount of partners that don't utilize our technology platform will be the small subset of incremental partners that we bring on going forward. So we don't think we're going to have dozens of partners over the next several years that want on that levels of technology platform. I would say if I had to guess today, more than 90% of our partners in the long-term will always love their technology platform. But at the same time, to the point I was making before, if it's a great company and a great brand, we want to be in business with them, we want to have a modular operator works for the widest group of good partners to get in business with. As it relates to economics, I don't think that it would look so different than if someone had bought -- in this case, the department bought fulfillment, customer service and order processing; I'm not so sure that it would look different than as the partner would have bought fulfillment technology and order processing but not customer service. I think it's fairly similar if you look at the [red sheet] that were received it's kind of historical to the same amount that we've had that someone is buying two or three or three or four services, I think it's pretty consistent.

Colin Sebastian - Lazard Capital

Okay, so there's just as much leverage in those other --

Michael Rubin

Just too much leverage, same term, same model I mean we won't look any different from your perspective.

Colin Sebastian - Lazard Capital

Okay, in the marketing services segment, could you talk a little bit more about where you're gaining the most traction there is that in placing the advertising or some of the other value-added services and are you trying to add marketing deals that are not with your existing partner base. And then lastly just an update on how you're feeling about the 50 million plus in EBITDA that you talked about before? Thank you.

Michael Conn

Sure, as it relates to marketing services, we certainly feel really good about that business and there is really four or five such areas within marketing services. You've got the core website about the design investments the companies are making and the best example that would be the big business that we do with Dick's Sporting Goods during the third quarter. We think if that represent an enormous opportunity and that big brands and big retailers are quickly figuring out that this is the best marketing vehicle and they are going from not want to spent money beyond what made sense from e-commerce economic perspective to saying this is where our consumer is going and we've got to invest here and they are quickly moving budget dollar and I think we are going to see is this be a nice growing part of our business. Another area is on-line marketing itself and certainly I think everyone knows there's a big shift going from traditional advertising to on-line marketing that continues to grow. Our studios where we do the different photography and content work for several partners is also definitely doing nicely as well. So, I think with the marketing services, we have several different areas and I think really they are all doing well and all growing nicely and all have tremendous demand.

As it relates to the $50 million number for '07, I think what I said here is I don’t think a lot will exchange the dollar, certainly not making any -- we're not going to put out guidance until next year, but certainly our outlook everything changed so then in it we feel like we have tremendous momentum in business, and feel great about the top line feel great about our desire continue to increase the bottom line and continue to make the right investments in the business for the long term.

Colin Sebastian - Lazard Capital

Okay, so no change to that outlook?

Michael Rubin

It did seem logical to me.

Colin Sebastian - Lazard Capital

Thank you.

Operator

Our next question is from Christa Quarles of Thomas Weisel.

Christa Quarles of Thomas Weisel

Hi, couple of questions. I was wondering just a couple of follow-ups, I guess on the marketing services side, I was wondering if you could indicate what percentage of revenue you think that might end up being for 2006 and just how many people you might have devoted to the effort right now? And then I have a follow-up.

Michael Conn

As far as percent of revenue, you know, it's not something that we've broken out last call, we said about $10 million for the year. I think that's a reasonable rough approximate. That's not a specific number we intend to break out in the near future. It's in the 100 people range today. I think a little bit -- probably still a little bit north of that, but it's in that range.

Christa Quarles of Thomas Weisel

Okay. And then how are you going about monetizing multi-channel and then when we speak to partners, it sounds like through additional fees, but you're not necessarily yet able to capture sales that were generated say on-line in the offline environment?

Michael Rubin

I think today if you look at our partners, we have got many of the great multi-channel brands. I think we've only began to scratch the surface on how to monetize that. And there is many ways we are going to do that. If you look today of our 60 partners, maybe 20 or 25 are brick and mortar retailers and I think I mentioned in my prepared remarks that three do today buy, on-line pickup in store, I believe that in five years, most retailers will do buy on-line, pick up in store. That represents an enormous incremental opportunity and incremental fees to GSI. Another example of that could be in-store ordering where a consumer goes to the store, the store doesn't have the merchandise they want and the consumer uses an in-store -- the sales associate uses an in-store ordering system to capture that sale. Today we do that in three or four partners and again I think we will do that in most partners over time. Another great way that we do is through marketing and services as you just diluted, we talked about this brand new business that is first year we will have approximately $10 million of business. We believe it's a great opportunity for us to monetize the dollars the people are spending, the space to have them invested in the website through the GSI Marketing Services Group and through spacing online advertising with GSI itself. I think if you're seeing us just begin to scratch the surface, but again the most important thing from my perspective is to get in business with the best partners that are going to make all these investments over time and with them we are going capture more share of the ultimate (inaudible) of these companies over time.

Christa Quarles of Thomas Weisel

And this is the last question on the new baby and the other you find, I guess, how was the structure of that influenced by the fact that you are already working with Babies "R" Us?

Michael Rubin

I don't think it was influenced at all.

Christa Quarles of Thomas Weisel

Okay thanks.

Michael Rubin

Thank you.

Operator

Our next question is from Aaron Kessler of Piper Jaffray.

Aaron Kessler - Piper Jaffray

Hi guys, good quarter. Couple of quick questions here. First in the sales and marketing know that the few percentage points in the percentage of revenue, can you give us a little color into that -- we're thinking about the percentage growth profits or something? And one follow-up.

Michael Rubin

I think really it is where virtually all of our variable expenses hit though. Percentage of merchandised sales, percentage of gross profit are both going to give you a better indicator there. There you can actually see when you look at that way. They are actually driving pretty good variable operating efficiencies through the business.

Aaron Kessler - Piper Jaffray

Great. And in terms of the percentage of the partner fees, can you give us some indication of where that looks like going forward here, [estimates dips] in Q4 for Toys “R” Us deal, and price needs backup in Q1, any direction in terms of percentage of partner service fees?

Michael Conn

Yeah, I mean I think that the, you know, if you look at -- I think where you get that is just the service fees as a percentage of non-owned merchandise sales which is, you know, I think would look to decline sequentially in the fourth quarter because of the mix of partners and where we're driving service fees from in the quarter, which is a seasonality factor. I think beyond that, I mean I think we've sort of gone down into the low, you know, 20 high-teen type of range, which I think is consistent with where we would expect to see a trend going forward from here.

Michael Rubin

And it's always important to remember that a lot of the reasons for the changes in percentage have to deal with what services a company is buying from us. So the company is not buying, fulfillment is an example and that’s was a big business by its nature. It's not that we’re making less money so we’re providing less fees for the customer. When you figure out the percentage, its going to be a low percentage itself not because we're providing less fees or less services.

Aaron Kessler - Piper Jaffray

Got it. Great. Thank you.

Michael Conn

Great. I think we have time for one more question.

Operator

Question comes from Chad Bartley of Pacific Crest.

Chad Bartley - Pacific Crest

Hi, thanks, just a quick follow-up on Toys "R" Us. I think a quarter ago your guidance implied around 140 to 150 in the second half NMS for Toys "R" Us, and I do the numbers there. Relative to (inaudible), this quarter, the non sports NMS was ahead of our expectations little bit. Can we attribute the strength, primarily to Toys "R" Us, maybe a little bit, you guys being conservative over the broader base, and across its multiple categories.

Michael Conn

Yeah, I wouldn’t get Chad, know, sort of specific partner results, but I would say, you know, here I'm inconsistent with what I said in my prepared remarks, and I really saw a broad based strength throughout the quarter, so, it certainly wouldn’t draw the conclusion that strength was driven by a particular partner.

Chad Bartley - Pacific Crest

I guess it’s a quick follow-up, what I'm trying to get out of your initial take, you know, with that, how is that looking now, one quarter out? Is it fairly in line, is it perhaps a bit conservative? I'm just trying to get a sense of how Toys "R" Us is trending.

Michael Conn

I mean I think I guess without being too specific, certainly, you know, no surprises to the negative. We feel good about the business and the relationship as Michael indicated. So, you know, overall we feel, you know, we feel positive about the business, and including relative to what we thought we would see.

Chad Bartley - Pacific Crest

Okay, thanks very much.

Michael Rubin

Thanks, everybody for joining us on the call. We look forward to following up with you after fourth quarter results.

Operator

Ladies and gentlemen, this concludes the conference. You may now disconnect. Have a good day.

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Source: GSI Commerce Q3 2006 Earnings Call Transcript
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