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GSI Commerce, Inc. (NASDAQ:GSIC)

Q2 2007 Earnings Call

July 25, 2007 4:45 pm ET

Executives

Michael Conn - EVP Finance & CFO

Michael Rubin - Chairman, President & CEO

Analysts

Anthony Noto - Goldman Sachs

David Joseph - Morgan Stanley

Robert Peck - Bear Stearns

Shawn Milne - Oppenheimer Funds

Colin Sebastian - Lazard Capital Markets

Jim Friedland - Cowen & Company

Scott Devitt - Stifel Nicolaus

Christa Quarles - Thomas Weisel Partners

Mark May - Needham & Company

Presentation

Operator

Good day, ladies and gentlemen. Thank you very much for your patience and welcome to the fiscal 2007 second-quarter operating results of GSI Commerce. My name is Bill and I will be your conference coordinator for today. At this time, all participants are in a listen-only mode. However, we will be conducting a question-and-answer session towards the end of today's conference. (Operator Instructions) As a reminder, today's conference is being recorded for replay purposes.

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

Michael Conn

Thank you. Good afternoon, everybody, and welcome to the GSI Commerce conference call for the second fiscal quarter ended June 30, 2007. This is Michael Conn, GSI's Chief Financial Officer, and I am here with Michael Rubin, our CEO. I would 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, merchandise sales, and non-GAAP net income, and certain ratios that use these measures. In our Form 8-K, which is located on our website at gsicommerce.com under SEC filings, 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.

As you may have noticed also, these measures were available to you a little bit earlier today than normal. We did have a mix-up with an outside provider that caused our release to inadvertently be pushed out early to the SEC. So as you also note, we did put out the actual press release as a result of that as well. I guess you could say with all of our focus on international expansion, we got a little bit confused about time zones here.

On to the results of the quarter. We had an excellent second quarter, with both merchandise sales and profitability ahead of our expectations. Net revenue increased 10% versus last year to $131 million, with 68% growth in service fees and a 6% decrease in product sales.

Non-GAAP merchandise sales or total transaction volume through our platform increased 52% versus last year to $316 million, with 13% growth in sporting goods and 71% growth in other categories. This is on top of merchandise sales of 52% and 53% in the second quarters of fiscal 2006 and fiscal 2005, respectively.

The spread between net revenue growth and merchandise sales growth was wider than recent quarters due to a decline in product sales caused by one non-sports partner that impacted the year-over-year change in this metric by more than 2,000 basis points. While the impact from this was a little greater than we had expected, we had forecast this general weakness and had included it in our previous guidance.

Service fees, on the other hand, were stronger than expected for the quarter, driven by better-than-expected merchandise sales, and strength in marketing services. Focusing on merchandise sales, 11 partners had comp store sales of 40% or greater during the quarter, and four partners had comp store gains of more than 100% during the quarter.

In general, we saw strong demand across most stores on our platform. Our three largest categories during the quarter were apparel, toys and baby, and sporting goods, while our three fastest-growing categories were jewelry, health and beauty, and home.

Growth in the sporting goods category was slower this quarter compared to recent trends, as some product categories that had been performing strongly for us cooled off. We do expect sporting goods merchandise sales growth to accelerate in the second half of the year.

Our gross margins in the quarter improved more than 1,000 basis points from last year to 49.9%, driven by 340 basis point improvement in product margins and strong growth in service fees. The fact that sporting goods accounted for a higher percentage of product sales drove the product margin improvement.

Operating expenses were generally in line for the quarter, with the expected drag from the startup expenses for our new fulfillment center. Variable operating efficiency in our fulfillment and call centers was better than planned.

Loss from operations was $9 million compared to guidance for a loss of 11 to $12 million. Adjusted EBITDA was positive $700,000 versus guidance for a loss of 1 to $2 million.

Net loss for the quarter was $5 million compared to guidance for a net loss of 6.5 to $7.5 million. Non-GAAP net loss was $3.5 million compared to guidance of a loss of 5 to $6 million. The upside in our earnings metrics was driven by the upside in service fees and better than planned variable operating efficiency.

Looking at our balance sheet on a year-over-year basis, cash and marketable securities were flat at $128 million. On a trailing 12-month basis, inventory turns remain strong at 8.2. Capital expenditures for the quarter were $13 million. I would note that our recently completed convertible bond offering was a fiscal third quarter event, and the proceeds are not included in our June balance sheet.

Turning to our guidance, let me first cover changes to our full-year expectations. For net revenue we are guiding to a range of $721 million to $751 million; that is from a range of 710 to $760 million. The modest reduction to the top end reflects the product sales versus service fee mix trends that we saw in the second quarter.

For merchandise sales, we are guiding to a range of $1.645 billion to $1.705 billion from a range of 1.6 to $1.7 billion.

For income from operations we are guiding to 10.5 to $12.5 million from 9.5 to $12.5 million. For adjusted EBITDA, a range of 53 to $55 million from 52 to $55 million. Our revised net income range is $41.3 million to $42.5 million, reflecting an increase to the bottom and top end of the ranges.

As a reminder, our methodology for non-GAAP net income is to show this number taxed at our annual effective rate of 38.5%. We are guiding non-GAAP net income to $15.4 million to $16.6 million; that is up from 12 to $15 million previously.

Our expected capital expenditures for the year remain unchanged at 50 to $55 million.

Consistent with our prior guidance, we expect year-over-year declines in our third quarter for our profitability metrics of income from operations, adjusted EBITDA, net income, and non-GAAP net income as we continue to incur costs related to the startup of our new fulfillment center, including costs related to transitioning partners into this facility, and as our technology spending peaks for the year due to heavy launch activity. All this is intended to have us well prepared for expected strong year-over-year growth in the peak fourth-quarter holiday season, which drives our annual profitability.

Guidance for our fiscal third quarter is net revenue in the range of $133 million to $143 million. Merchandise sales we're guiding to a range of 299 to $319 million. The loss from operations we are guiding to a loss of 14.5 to $13.5 million; and a loss for adjusted EBITDA from 3 to $2 million. Our net loss range is $8.1 million to $7.51 million. We are guiding non-GAAP net loss to $6.4 million to $5.8 million.

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

Michael Rubin

Thanks, Mike. Let me start by saying I am very pleased with our 2007 fiscal second-quarter results. The underlying health of the macro trends in e-commerce, coupled with our continuing focus on growing the business, helped to achieve or exceed our second-quarter guidance.

As we noted on our last two calls in February and in April, we said that we expect to see year-over-year declines in our profitability metrics during the second and third quarters due to the timing of investment spending, particularly related to startup costs of our new fulfillment center. Our third-quarter guidance includes expenses for scheduled launches and continued transition into our new fulfillment center.

That said, we believe we will continue to perform well in the second half of the year, and we are anticipating continued strong momentum.

Today, I'm going to update you on new partner signings, contract extensions, and store launches. I am also going to talk about the successful opening of our new fulfillment center, provide you with a management update, a progress report on our international and marketing services growth initiatives, and report on some of the enhancements we have made to our e-commerce platform that our partners use to grow their businesses. Finally, I will talk briefly about our successful effort to raise capital through our recent convertible bonds offering.

Our business development pipeline continues to be strong, and our sales effort have kept us on pace to reach the high-end of our goal of signing five to 10 new partners this year. It is interesting to point out that we are entering into more new partner agreements that include multiple Web stores. This is particularly true for us in the apparel category, where a partner may have several brands.

The apparel category continues to be a strong contributor to our sales pipeline, as we signed two new service fee partners in the category during the quarter. We recently announced that we were selected by the Nautica and Kipling brands of the VF Corporation to provide them with full-service e-commerce solutions. Web stores for each of these brands are scheduled to launch during 2008.

The other new apparel partner that we signed during the quarter is a multibillion-dollar apparel and lifestyle company that manages several great brands and has a global following. We are scheduled to launch the first of three Web stores for this partner this fall. The partner's two additional Web stores are scheduled to launch during 2008. We will provide more information on this partner and its online business at a future date.

During the quarter, we announced that we signed a long-term agreement with the NBA to provide all the leagues with a full e-commerce solution that also includes online marketing services. Today, I'm happy to announce that just last week we launched the NBA's Web store on our e-commerce platform; and we're now gearing up for the 2007-2008 tip-off this fall.

With the signing of NBA, we now have e-commerce agreements to operate the online stores for the major professional sports leagues in the United States including Major League Baseball, the NFL, the NHL, and NASCAR. The NBA's selection of GSI is a testament to the leadership position we have entered into delivering quality end-to-end e-commerce solutions to professional sports organizations and sports leagues.

On the launch front, in addition to the NBA, we successfully launched Gordon's Jewelers in April, which is the third online store we have launched for our partner, Zales Sic Corporation. In the past 30 days, we also successfully launched a new online store for Charlotte Russe, an apparel partner that we signed earlier this year and which is now gearing up to add additional features, functions, and merchandise to the new online store this fall.

Additionally, we plan to launch five additional online stores during the remainder of the year, which include online stores for the Hershey Company, BCBG Max Azria, and three unnamed partners -- another apparel partner that we signed in 2006, an unnamed publicly-traded multibillion-dollar specialty retailer which enters us into our 13th retail category, and one store for the new multibillion-dollar apparel and lifestyle company that we signed during the second quarter which I mentioned earlier.

It is important to note that we believe that we have the infrastructure and resources necessary to complete all the second-half launches on schedule and that the expenses associated with these launches are factored into our guidance. To provide additional clarity, please also note that the new partner signed after July 1 generally schedule to launch their online businesses during the following year.

To date in 2007, we have signed e-commerce agreements with six new partners for a total of nine new online stores and launched five online stores -- RacingOne, Charlotte Russe, Gordon's Jewelers, the NBA, and Elizabeth Arden. We also have four online stores already lined up for 2008 including Nautica, Kipling, and two stores for the unnamed apparel partner we announced today. We are excited to already have this visibility into 2008 launches.

On the partner extension front, we extended our multiyear e-commerce agreements with iRobot and Linens 'n Things. Additionally, I want to mention the new strategic alliance that we announced during the second quarter between GSI, QVC, and the NFL, which created a multichannel marketing effort for the NFL's licensed products on QVC's telecast and QVC's Web store. Born out of the successful e-commerce partnership we established with both of these companies, this alliance is an example of the opportunities potentially available to more GSI partners.

Next, I am very excited to announce that on June 22, we officially filled our first order from our new fulfillment center in Richwood, Kentucky. Located just south of Cincinnati, the new facility is our largest at approximately 540,000 square feet. When you include the new Richwood facility with our two other distribution facilities and along with our supplemental storage space, we now manage approximate 2 million square feet of fulfillment space.

The Richwood facility was designed to be built out in phases. We have completed Phase I and we expect to have the facility fully built out during the first half of 2008. We anticipate our full investment in the facility to be approximately $30 million when complete, and we have invested approximately $23 million of that this year.

Richwood is our most automated facility to date, allowing us to replace some of the more manual processes found in our other distribution centers. This automation creates efficiency by reducing the labor needs of the facility while handling greater volumes more quickly.

I next want to talk about a recent addition to our senior management team. In May we announced that we added Scott Hardy as our Executive Vice President of Business Management. This is a key leadership position within the Company as it has direct responsibility for overseeing our partners' growth, profitability, and satisfaction. Because our success is tied to the success of partners, we need to continually deepen and strengthen the relationships we have with them.

I am confident that Scott's experience running the regional consumer businesses in the Americas for BearingPoint and developing and implementing large commercial engagements in areas such as business transformation, customer management, workflow optimization, merchandising the store operations will provide to be a tremendous asset to our partners.

Last quarter, I introduced two emerging growth initiatives for the Company -- international and marketing services. Today, more than ever, I am convinced these two areas represent tremendous opportunity for GSI.

Let me begin with international. During the quarter, we announced that we expanded the scope of our e-commerce partnership with iRobot to include the launching of their e-commerce operations in Europe during 2008. This is a significant milestone for our Company in that iRobot is the first US partner to sign an agreement to extend their GSI relationship internationally. I believe this is just the tip of the iceberg for us.

Recent conversations I have had with existing partners and prospects tell me that they are looking for a solution provider that can handle the complexities associated with supporting their e-commerce efforts in multiple countries overseas. These are the type of conversations I love to have, because they validate a need and our belief that our full-service platform can be a strategic differentiator for us as we expand overseas.

To that end, we continue to make aggressive investments toward internationalizing our technology platform. Steve Davis, our executive who is relocating to Spain this fall to run our international operations, continues to develop his business plan while evaluating strategies that address opportunities that could supplement our efforts to extend our domestic platform throughout the world.

Next, I would like to update you with several recent achievements made by our interactive marketing services agency, GSI Interactive. I would like to start by announcing that one of the agency's largest partners recently renewed its marketing agreement for another year. The contract extension, which has a multi-million dollar service fee potential, includes e-mail and affiliate marketing and a creative design retainer. I call attention to this partner contract extension because it demonstrates the value the agency is providing to the partner based and the credibility the agency is establishing. As it continues to build a track record, I expect that the agency will create recurring revenue stream with its contract renewals.

The recent integrative marketing award presented to us -- to the agency by LinkShare is a more public example of the performance value the agency is delivering to our partners. In this instance, the agency was honored for a successful affiliate marketing campaign that it developed for Toys "R" Us during last year's holiday season.

Last week, the agency completed and successfully launched a full-store redesign for ShopPBS. In addition to providing a fresh new look and feel to the Web store, the project added several new capabilities to this site including parametric search and navigation, express shop and menu card, a catalog quick order feature, as well as other functionality designed to enhance a customer's shopping experience at ShopPBS.

The second quarter also saw an agency first, where we engaged to provide marketing services for a retailer not currently using GSI for its e-commerce business solution. This non-platform partner signed up for the agency's RAVE program, or Rapid Assessment Envisioning Exercise, which is designed to provide companies with a quick and effective method for developing an actionable roadmap used to create or enhance a website or an online store.

After the agency completes a RAVE for the company, it typically pitches the company to do the recommended work. I make a point of calling this out, because while the agency is focused on selling and delivering interactive marketing services to our current partners, I expect the agency will also be opportunistic in building business outside of our partner base, and offering is services to non-platform partners.

As we invest in agency, we build the depth of its overall offering by adding and expanding its capabilities. One such new capability that we are adding is a state-of-the-art usability lab. Through the use of sophisticated software and monitoring systems in a test environment, we can monitor and measure consumer interactions with our partners' Web stores right down to recording the shoppers' eye movements. This enabling technology provides the agency with solid feedback that it can use to suggest and create improvements that affect a shopper's experience on the site. The agency's use of this technology was instrumental in the redesign of the Dick's Sporting Goods Web store and more recently was used for a usability project and plan for enhancements to the Charlotte Russe Web store.

In recent discussions I have had with partners, they tell me that they are excited about our ability to offer them interactive marketing services in addition to our core platform services. They view our marketing services as providing them with the perfect complementary service to the e-commerce relationship with GSI.

On the other hand, offering interactive marketing services to non-platform partners provides us with the opportunity to showcase the full spectrum of our capabilities. I expect that ultimately marketing services will grow the opportunities we have to expand the total number of partners we have on our core e-commerce platform.

I would like to turn now and provide an update to our product roadmap. During the second quarter partners deployed several of the latest features and functions developed through our product roadmap on the Web stores. Our new Decision Wizard functionality was developed and deployed on The Sports Authority site for men's and women's running shoes. The feature helps consumers narrow product searches and quickly while dynamically displaying images of the search products on the shopper's screen.

RadioShack added a new store locator using Google maps and is now the second partner to deploy this functionality associated with the powerful Web 2.0 feature.

Earlier this year, we partnered with PowerReviews to enhance the product ratings and reviews capability on our platform. During the second quarter, we implemented this new interactive community feature for 18 partners.

We also recently provided partners with a new search-adising tool that allows them to set up and promote selected products over others when search results are returned to a page. This new search-adising feature is also among the latest of a series of tools that we've developed to give our partners more control over the day-to-day operations of the Web stores.

It is important to point out that the large and growing annual investment we make in our product roadmap is the way we continue to enhance the technical features and functions that deliver strategic value to our partners' online businesses. We provide the bulk of this development effort for all roadmap initiatives while allowing the final interface design and customization to be managed by our partners. This provides each partner access to our platform investment while allowing them to implement the technologies in ways that deliver custom benefits to their businesses.

Finally, I would like to mention the success we had with our recent convertible bond offering where we raised $145 million, net of expenses. We have said that we plan to use the proceeds for working capital, general corporate purposes, and possible acquisitions. This capital will enable us to pursue our growth initiatives.

Well, I have discussed in the past the Company's growth strategy, I want to take a moment to articulate the overall vision of where we are going and what we are building. Let's start with the core business.

Year-to-date merchandise sales are up 60%, and we have added several high-quality partners. Over the next five years, based on projections for continued strong industry growth, we believe it is reasonable to assume merchandise sales from existing partners will continue to see strong growth. We also believe we will continue to add partners at least as fast as we have historically. Said another way, I think our core business had a lot of runway.

In addition to the core business, we are increasingly excited by our emerging growth opportunities of international marketing services that both enjoy favorable secular trends and are natural extensions for our business.

But what really makes the long-term opportunity for GSI so compelling is how these three pieces can fit together with an integrated world-class global solution of e-commerce and marketing services to great consumer brands. This is what we are working to build.

As I spend a significant amount of time talking with the leadership of our partners and prospects, I'm increasingly convinced that if we achieve our vision, the integrated solutions that we will be able to provide will be of tremendous value to the market and, in turn, enable us to create significant shareholders' returns.

In summary, our second-quarter performance as well as that for the first half of the full fiscal year has met or exceeded our expectations. As we look to the second half, we are confident that we will be able to continue our success by executing against our plans and managing the business effectively.

The first-half performance has set us up to again reach our annual goals of increasing our profitability and expanding our margins while continuing to drive growth in the business.

With that, I'll open the call up for questions.

Question-and-Answer Session

Operator

(Operator Instructions) First question comes from the line of Mr. Anthony Noto of Goldman Sachs. Please proceed sir.

Anthony Noto - Goldman Sachs

Thank you very much. I was wondering if you could comment a little bit more on the category that underperformed, that you had mentioned.

Secondarily, Michael, I was wondering if you could comment on what progress you made on organic growth on the marketing services line, in terms of additional services adopted or penetration of clients, as it relates to new services. Thanks.

Michael Conn

Sure. You know, on the category we were talking to there was a couple areas that we mentioned that were weak. I think that first and most pronounced was a particular partner on the non-sports side that is an inventory owned partner. If you look at the product sales growth, which was down 6%, that year-over-year change was impacted by more than 2,000 basis points.

So I think clearly, it is in our results and we certainly will always have ups and downs with partners; but that was material impact that we did feel that we should point out.

I think if you look at where our guidance was, it was certainly something that we had looked for, but clearly a little bit more so on the weak side than we had expected.

Also note, 13% growth in merchandise sales for sporting goods was slower than we had seen in recent quarters. There, there's a few product trends that really had been hot for us that have slowed down; that did hurt us in the quarter. Flip side of that is, as we look to the back half of the year, as the licensed products category becomes much bigger for us, which has now become such a big piece of the business for us, we really do look for an acceleration in the sporting goods category in the back half of the year.

It is also important to note just where -- when you have weakness for us in a product sales category and strength as we saw on the service fee side of the business in nonowned inventory, it makes the net revenue look worse than really the underlying trend of the business. I think you can see that when you look at the gross profit line and how strong that grew.

Michael Rubin

To answer the question that you asked related to growth in the marketing services business, certainly on a year-over-year basis I think we are having certainly very nice growth from a marketing services perspective. But I think the latter part of the question you asked us is really the important part; which is kind of -- what type of additional offerings can we sell to both existing partners and new partners.

I would say if I look at the growth within the existing partners that we have to sell them new services, I think it is many times the existing size of the business. So I certainly believe we could double or triple the size of the existing marketing services business just from existing partners.

We certainly believe there is a lot of opportunity for us to continue to enhance and grow our capabilities and do new things. Again, we think that is just a terrific opportunity with existing partners.

Anthony Noto - Goldman Sachs

Mike Conn, can you at all comment on that one particular partner that underperformed, in terms of some of the factors that may have caused that? Was it lack of availability of inventory, pricing, marketing dollars spent, availability of the site?

Michael Conn

I would say without being too specific. I mean think I would say it is reflective of just trends more specific to that partner and their industry versus e-commerce at large. I think that if you look at the trends that we saw at large in our business, reflected by the 52% growth in merchandise sales, some of the just impressive comp results -- as I mentioned, I think, 11 partners with 40% or greater comps -- kind of is more indicative of kind of what we see as far as underlying momentum in the e-commerce industry. So I wouldn't characterize it as industry, e-commerce industry-related.

Anthony Noto - Goldman Sachs

Right, I get a sense of what you are implying. Then, the final question, I am sorry for so many. Your gross profit exceeded expectations by about $6 million and your EBITDA by about 2 as well as operating profit. Did you not have enough time to spend that upside in profitability back into the business, and it just hit the bottom line? Because I know you have said in the past you will continue to invest the upside.

Michael Conn

Yes, I think that as far as intra quarter, I think that that is always a bit of a challenge. I think that a little bit more in the third quarter will be spent; and I think that you see that reflected. But overall, I think it is a balanced approach. We have taken up the bottom end of the guidance to reflect some of that bottom-line improvement staying with us.

Anthony Noto - Goldman Sachs

Great, thank you.

Operator

Thank you very much, sir. Ladies and gentlemen, your next question comes from the line of David Joseph of Morgan Stanley. Please proceed sir.

David Joseph - Morgan Stanley

Yeah, guys. Thanks for taking the question. I think, Mike, you touched on something in your answer in the last question, whereby gross profit benefited from the mix shift. I guess as you saw the owned inventory actually decline for the first time and the service fees actually accelerate. It seems like you reset that mix a little bit in your guidance. But it doesn't seem -- so that should be benefiting your gross margin going forward. But it doesn't necessarily seem that those dollars are going to be flowing to the bottom line as much as you would expect, given the upside that you did see the guidance in Q2.

So I am wondering if you have increased your spending expectation for the second half of the year at all.

Michael Conn

Yes, I think that along the lines of what I am saying, I would say somewhat yes; I think that we continue to be focused on achieving our annual goals for the year. As we have had some upside both in the first and second quarters, we have brought up the bottom end of the range, I think similar to what we have done in the past,

As we do see some strength and some opportunities to also invest a bit more, we will do that. So there is a bit more investment spending. But also bringing up the bottom end of the range, which we think is a good balance. It is very much on track where we are comfortable that we can achieve our goals for the year.

David Joseph - Morgan Stanley

So there is no specific opportunity that you have identified for the second half of the year for that?

Michael Conn

I wouldn't characterize it as any one particular area. I think it is just more along the areas that we have been investing in.

David Joseph - Morgan Stanley

Okay, great. Thank you.

Operator

Thank you very much, sir. Ladies and gentlemen, your next question comes from the line of Robert Peck of Bear Stearns. Please proceed.

Robert Peck - Bear Stearns

Yeah, hi guys. Thanks for taking my question. I have one housekeeping thing and then a bigger picture thing. It looks like the sales and marketing line as a percent of revenues is one of the highest it has been recently, although just a little bit higher. I am wondering; how should we think about that line going forward? Are there any particular programs that we should be thinking about?

Then number two is, as we think about the money you recently raised, Mike, could you give us a little more clarity or guidance on what we should see that be going to? Is it primarily the bulk of that would be focused on international development? As that spills towards '08, how would that affect our thoughts on margins and CapEx in '08? Thank you.

Michael Conn

Sure. I think with sales and marketing, I think what is important to remember is really all variable operating expenses fall into that line. Actually the bigger chunks the better, fulfillment, call center and order processing. So one is just the strong growth in merchandise sales is going to bring up your variable expenses.

The other component hitting that right now is the opening of the Richwood fulfillment center, startup expenses related to that, which are new in the run rate, which don't really start to be absorbed until we get into the fourth quarter. So that is also a big impact.

So we certainly do look to get better results on that line (inaudible) percent to sales total beginning in fourth quarter going forward. But I think it will always bounce around a little bit as we have infrastructure investment spikes from time to time as we are adding infrastructure.

Michael Rubin

I will get the second part of the question, Bob. I think as it relates to kind of what are some of the investments that I think we are going look to make, kind of later in '07 and going into '08, I think realistically the area that is most likely to see some activity from a spending perspective is really going to be acquisitions that really help us to achieve our long-term goals.

I think there's really three areas that we look at. One would be kind of tuck-in type acquisitions, where the acquisition can help us from both a client and a scale perspective.

I think the second is marketing services area, where -- as I was just kind of answering Anthony's question earlier, as it relates to doing additional things with partners -- we think there are capabilities and great companies out there that we could add into the GSI portfolio and not only be able to serve our existing partners substantially better but also being able to serve the business's existing partners.

The third would be international. I think in the US, we have always walked in and kind of started warehouses from scratch. Started call centers from scratch. I think we have seen some small good businesses with local market experience. Good -- you know, the ability to give us some good capabilities to get to our international goal more quickly.

So I wouldn't look to see -- I think you could see us look to do different types of things within those three areas that I think are going to be all meaningful to help us to achieve our strategic goals more quickly.

Robert Peck - Bear Stearns

Thanks, guys.

Operator

Thanks you very much, sir. Ladies and gentlemen, your next question comes from the line of Shawn Milne of Oppenheimer Funds. Please proceed sir.

Shawn Milne - Oppenheimer Funds

Thank you. Thanks for taking my question. I wondered if you could just go quickly back to the one partner that had a tough quarter. I believe this is the last -- or we are anniversarying the last of the decent quarters from that partner. Is that easier comps going forward on that partner?

Michael Conn

Yes, if you actually look at the other product sales, which for us is in the schedule and the release; and you look at the back half of last year, we were actually down in that category in the third quarter and flat in the fourth quarter. So the comparisons are significantly easier for us in the back half there.

I think you can see that in the guidance, with the implied stronger growth in net revenues in the back half of the year versus what we saw in the second quarter.

Shawn Milne - Oppenheimer Funds

Right. Then there's five partners to launch before the holiday. I don't know how much level of detail you want to get into. But if you can just talk about where you are along the line on a couple of the bigger ones; trying to help us in terms of getting confidence around getting these sites up and running and launch expenses under control heading into the key holiday period. Thank you.

Michael Rubin

Sure. We certainly -- I think, one of the things we have continued to do is invest in the overall different organizations that launch partners for GSI. I think certainly, I would say that we made significant improvements in 2006; and I think again we have made significant improvements in 2007.

I think our guidance really factors in all the expenses that we think are associated with launching these partners. I think our confidence is very high that we are in a good place.

I think, again, when I look at the overall business, I don't think we have ever done a better job of launching partners than kind of where we are today. It's been a continual progression. So I think both we are confident in the launches and I think we feel that expenses are properly represented in our guidance.

Shawn Milne - Oppenheimer Funds

Thank you.

Operator

Thank you very much, sir. Ladies and gentlemen, your next question comes from the line of Colin Sebastian of Lazard Capital Markets. Please proceed.

Colin Sebastian - Lazard Capital Markets

Thanks for taking my question. And congratulations on the quarter. Just a couple. I was wondering if you could talk about the take rate in the services business. That looked like that ticked up sequentially. First of all, how should we expect that to trend seasonally over the remainder of the year?

Michael Conn

Sure, I think that one of the factors that has impacted that line, where it had been sort of trending down, was the move towards more of a mix of full-service deals and hybrid deals.

As we look forward there's a couple things that have been benefiting a little bit. One is marketing services and the strength we are seeing there. That is positive for that take rate.

Then the other component is as we start to see new deals launching, we have seen a real resurgence in full-service deals. So where we have signed six deals this year, all six have been full-service deals, so that also will be beneficial for the line.

I think, still thinking about the high teens ranges for the back half of the year is the right way to think about that.

I think kind of just going forward, I still think it is a reasonable range. It's a little bit hard to predict based on unknown mix. But I would certainly say trends like strength in marketing services and more full-service deals help that -- help that number. But there's always some unpredictability just based on that mix of where we see strength in partners and different take rates with different partners. So there is always some hazard in trying to get too precise on that number.

Colin Sebastian - Lazard Capital Markets

Okay, thanks for that detail. My last question is on the international opportunity. I was just hoping you could provide a little more detail on where you are, in terms of the ability to provide a full-service offering there, the progress Steve is making over there, and what holes you may have left to fill. Thank you.

Michael Rubin

Sure. I think the key components to having a full-service offering is to, A, have the technology platforms fully internationalized; and then, to have fulfillment, customer service, and business people to support the fulfillment customer service offering along with the technology platform.

From a technology perspective, we really recognized that we were going to start to aggressively pursue international this year, probably as early as sometime in early 2006. So we have been investing heavily in the platform since 2006. I would say that by the end of this year, we will have completed a large portion of the investment to fully internationalize the technology platform. I would say, a high double-digit percentage of sales.

As it relates to getting the other pieces together that we are going to look, I think it is more likely that we're go to buy than build. I think we have seen many good opportunities for us. I think it is more, for us, a decision of what are the right assets that we want to kind of add to the portfolio and putting that together.

I would hope by the end of 2007 that we can offer a full-service solution that is fully put together by the end of 2007. I think we are on track to accomplish that.

Again, I will say that I think that makes us very, very unique and very special. When I look out in the market, I have spent some time in Europe over the last couple months, back and forth a few times, certainly what I have seen is that we have established the GSI model -- the end-to-end solution -- here in the US. It doesn't exist outside of the US.

I think what we are seeing is a tremendous amount of receptivity and really nobody that has it together. So we think, as well as we have done in the US -- and we quite frankly feel great about the business -- we think internationally the opportunity is even bigger. I think the more time I spend studying the international marketing, getting more involved in with it, I think the bigger I think the opportunity is.

Colin Sebastian - Lazard Capital Markets

Great, thank you very much.

Operator

Thank you very much, sir. Ladies and gentlemen, your next comes from the line of Jim Friedland of Cowen & Company. Please proceed.

Jim Friedland - Cowen & Company

Thanks, a couple numbers questions and then a follow-up. First, for the $150 million convert, can you give us an idea of with the fully diluted shares are going to look like for Q4 and year-end? Also, what are the net proceeds?

Then a follow-up on that is can you give us an update on the alternative payments that you guys are using, like PayPal and Google Checkout, especially, since we haven't seen too much promotion going on with Google Checkout in recent months?

Michael Conn

Sure. On the convert, we kept the math pretty simple on the conversion price. It's $30 with a $150 million face value when all is said and done. So there is 5 million shares that are underlying that. I think as you see with the existing convert, it's -- they are in our share count on (inaudible) converted basis. So in quarters where we lose money typically it is antidilutive. They are not included in the fourth quarter.

We would expect those shares to be in the share count in the quarter; but is also a quarter (inaudible) back out the interest expense as well as the deal cost, the amortization. We can help you from a modeling perspective off-line with that. For Michael, on the alternative payments question?

Michael Rubin

Sure. We have been and remain a very big believer in alternative payments. I think if you look at these 70-ish sites in the GSI portfolio -- because maybe we have 65 partners, maybe 70, 75 sites that we operate -- I would venture to guess that probably 40 to 50 are using at least one alternative payment.

We think that we are by far and away the leader in the alternative payment space, having integrated Bill Me Later for several years, PayPal and Google Checkout. I think we are really happy with where we are.

We are continuing to see broad adoption amongst our partners. Every month I think we have more partners adopting additional alternative payments.

As it relates to kind of who is doing well and who is not, we still see Google Checkout as the highest percent penetration of the different alternative payments. I know the question you're asking which is Google was doing a lot of promotion earlier on; and they're now not doing any promotion. We have been really pleased with the penetration rates with Google Checkout, even without any promotion. Certainly I think that just speaks to the underlying strength of the product.

In addition to that, I think PayPal continues to move along and is certainly doing all right. Bill Me Later is still certainly doing nicely as well.

Jim Friedland - Cowen & Company

Is there a follow-through impact on click-through rates as well? As Google has talked about having fewer drop-offs in the checkout process, so increasing conversion rate with checkout. Have you seen any of that evidence?

Michael Rubin

I haven't studied it myself. I certainly do believe that from everything I know, from the little bit of interaction I have directly with people at Google and also what I hear from my team, I think Google is doing a lot to make partners that are integrated with Google Checkout more successful, from the search process all the way through the checkout process.

So certainly, I continue to -- even without any of the promotion, I'm continuing to hear lots of momentum just in excitement from our partners when they kind of hear the plans that Google has, as far as how they are going to drive the business. We certainly hear a lot of good things.

Jim Friedland - Cowen & Company

Great, thanks.

Operator

Thank you very much, sir. Your next question comes from the line of Scott Devitt of Stifel Nicolaus. Please proceed.

Scott Devitt - Stifel Nicolaus

Okay. Thank you. The question just related to the new fulfillment center in Kentucky being a highly automated center. I am just wondering if you could talk through how you have maybe resegmented inventory or partners amongst the various facilities at this point.

Then along those lines also, with the partner announcements this year, if you could just update us, now that the facility is open, on your capacity in the US and when you think you will need another facility. Thanks.

Michael Conn

Sure. I think that the automation specific to the facility in Richwood is related to sortation for multiline orders. So a partner that has a typical order that has multiple products associated with it, where those products all easily move through conveyor belts, is the type of partner that works really well for this facility. A lot of our apparel partners fit very well in that facility and they will have a lot of heavy concentration of apparel partners. There's also several hard goods partners that fit well within that facility.

So it is a type of partner who is really -- the fact that we have a number of partners that are of that characteristic, that enabled us to be able to justify the investment in this facility. It is a big investment upfront that will pay real good returns to us down the road with the efficiency that we can generate out of that.

As we look to other facilities over time, I think there's different types of automations with different types of -- groups of partners that will also be able to work for us. I think right now, based on kind of the current growth rate of the Company and what we expect over the next few years, we would say a new facility of this magnitude would probably be in 2010.

But there is clearly potential based on accelerated growth that could be needed sooner. But I think sort of kind of current thinking with sort of certain reasonable expectations that for growth you would think about 2010 for another facility. And it would probably be another automated facility at that time.

Scott Devitt - Stifel Nicolaus

Thank you.

Operator

Thank you very much, sir. Ladies and gentlemen, your next question comes from the line of Christa Quarles of Thomas Weisel Partners. Please go ahead.

Christa Quarles - Thomas Weisel Partners

Thanks. First, I guess I was anticipating the weakness at your non-sporting goods owned partner. But you had highlighted quickly that you had some merchandising issues on the sporting goods side, and you thought those were going to reverse. I was just wondering if you could add some clarity.

Michael Conn

Yes, there were a few product categories that had just been particularly strong for us for several quarters, that were real good sort of drivers of upside in the sporting goods business, that we have seen cool off. I think that as we look at the history of our sporting goods business that this kind of cyclicality of hot products is not an unusual phenomenon. So I think that it was not something that is something that we haven't seen before. I think that hot products come and go; and I think that we will see further strength there.

I think that as we look again to the back half of the year, just the mix of business in terms of which partners are bigger in the back half of the year -- particularly as we go even into the third quarter -- that, coupled with the launch of the NBA, are all things that give us confidence that we will see stronger year-over-year growth in sports.

Christa Quarles - Thomas Weisel Partners

Got you. Then I wanted to confirm, I know you guys had said in the past that you wanted to do accretive acquisitions. But I wanted to have you reaffirm that and then discuss earnout structures or how you think potential deals might be structured.

Michael Rubin

Sure. I think, generally, our mentality is that we do want acquisitions to be accretive. I think that certainly we evaluate every acquisition on a series of different criterias -- the financials of the acquisition, the capabilities, the size of the acquisition. Certain things could be so -- you could look at certain acquisitions that are so small it may not -- maybe kind of almost meaningless. It may get you a capability, it may get you a specific country asset that we need in international. But is it really meaningful?

But I think as a whole, we're certainly looking for acquisitions that are accretive that are certainly of any size. You never want to say never because we just learned that in business 101. But that is certainly the mentality and the type of things that we're looking for.

Christa Quarles - Thomas Weisel Partners

Okay. Then two more. One, just the tax rate for 2008. I know you guys have had some onetime benefits in '07 and '06. I assume those are not going to continue. I am just wondering if you could add some clarity.

Michael Conn

Yes, it's the correct expectation. So I would say for now, the effective tax rate for the Company has been 38.5%; and I think that is a good rate to use for planning purposes. It is always subject to bounce around based on business activity. But that is what I would use for planning.

Christa Quarles - Thomas Weisel Partners

Then the final question, I guess, is just around talent in the marketing services space. I am assuming that there is a decent amount of it potentially floating around, post the aQuantive, 24/7, DoubleClick deals. I was just wondering if you are more bullish from a staffing perspective now or just if you could just discuss where that is.

Michael Rubin

I am not sure that I would say that there is -- all that talent has necessarily flowed into the market yet, anyway. If you look at the deals you just named, none of the three are closed. So I think there will be talent floating around from those companies combined. I am not sure that we have seen it in the market yet.

I would say that for our Company, staffing is certainly something that has always been an issue just because of how fast we are growing. Certainly, we have really high expectations of the quality people that we hire and we are growing at a really fast rate. So I think that talent management, talent acquisition is always something that we're focused on.

I would not say it is particularly more difficult or particularly more easy at this time. I think it is kind of something we have a consistent focus on, and I think we have executed well on. And I think it will continue to kind of be the same kind of scenario.

Christa Quarles - Thomas Weisel Partners

Okay, great. Thanks.

Operator

Thank you very much, sir. Ladies and gentlemen, your next question comes from the line of Mark May of Needham & Company. Please proceed.

Mark May - Needham & Company

Thanks. My understanding, first just to circle back on the sporting goods. My understanding was historically the category had tended to grow in the mid to high teens on a category basis. Is the 10% that you did in the quarter -- I know it sounds like hot products impacted that number. But just going forward, is the 10% number a better number to use? Or is this sort of mid to high teens a better number?

Along those lines, one of the hot products I think that you have had over the last few quarters has been Heelys. Are we to read into it that maybe that is one of the products where growth has slowed in the last quarter?

Michael Rubin

Sure. First of all, the growth in sports business was 13%. Certainly I would not suggest that we were going to grow anything less than the kind of high teens which was the higher end of what you suggested on a go-forward basis.

I certainly don't want to comment on what vendor or a few groups of vendors really cooled off. But what I can tell you is I don't think the trends that our sporting goods partners have seen are any less -- different than the sporting goods retailers are seeing in their stores, as it relates to particular brands that might have been really hot historically that may have slowed down a bit.

The only difference with us may be if a product starts off and is really hot, sometimes we get it before it fully makes it into stores. So it might do better on the Internet upfront. So you get a little bit of a free benefit. Certainly I think there a few products that we enjoyed that free benefit with for a couple quarters throughout the time.

But I'm really bullish on the sports business. I think 13% growth was kind of an outlier. I think you're going to see it return to very nice growth rates. We are going back to -- going into the third quarter, you have got NFL, which is seasonally meaningless in Q2 and certainly meaningful in the third quarter. You have got the launch of the NBA. Overall, we feel really good about the sports business and where it is going.

Mark May - Needham & Company

Okay, thanks, Mike. Then a follow-up. A couple of the questions I was getting in this afternoon had to do with what is implied for the EBITDA and the margin in the fourth quarter. I think the guidance implies something like a 350 to 400 basis point year-over-year improvement in the margin, something like a 50, 55% incremental EBITDA margin in the quarter.

I mean, that is not unprecedented; I think you guys did that in late '04 or early '05. But just wondering if you can sort of talk about the operating expenses required in fourth quarter, and give us some confidence that you guys can hit this with a pretty significant but not unreasonable EBITDA number in the fourth quarter.

Michael Conn

Yes, I think that if you look to -- and it is a good question. I think if you look to really the fixed lines within our expenses -- product development product and G&A -- certainly on the product development side we would expect it to be down sequentially in the fourth quarter. G&A flat to down sequentially in the fourth quarter as well.

So you really have fixed expense base that has some incremental spending in the third quarter. A lot of it is associated with launches and contract labor for technology that hits those areas. So I think that you have that as an opportunity where you get tremendous leverage.

The other piece of it is the sales and marketing line where if you look at it as a percentage of merchandise sales, and the fact that that is really the driver of it, because so much of that line is variable. You have the fact that from a mix perspective you should actually see sales and marketing lower as a percentage of merchandise sales than what you have seen in second, and what you would expect for third quarter.

So you will get a benefit there. Part of that is also just driven by there is a fixed competitive to that. With the significant growth that we will see in merchandise sales, you'll see a leveraging of the fixed component of that as well.

Mark May - Needham & Company

Okay, thanks. Lastly on CapEx, as we are all thinking about '08, you know you mentioned the $30 million number for the facility this year. I'm sure not all of that is kind of one-time in nature. But what portion of that is one-time in nature? So that we can start to build some sort of a CapEx model for next year.

Michael Conn

Sure. I think that the $30 million for the facility, $23 million of that hit this year, so you have got about $7 million remaining on that. There is other capacity related investments that we would expect to be making just in fulfillment as well as some in call center for 2008, really revolving around existing facilities, but still building out incremental capacity for those existing facilities.

As well as technologies in area that we would expect to continue to invest heavily. So certainly I think that the range that we are seeing for CapEx this year shouldn't increase for next year. I think there's some opportunity that it could be a bit lower; but I wouldn't look for a significant drop-off in CapEx. But I also wouldn't look for any kind of increase in CapEx, either.

Mark May - Needham & Company

Okay. Maybe if I could just ask one more question, maybe for Michael Rubin. You made a comment earlier that you're confident about your pipeline in terms of new service customers. Longer-term, you expect to continue to add new customers at the same rate that you have historically. But one thing that is pretty noticeable recently is that the size of the customers you have been adding have seemed to be smaller from an online GMS perspective.

Just wondering if you can comment about that. Are you seeing in your pipeline any change in the type of customers that you are talking with in terms of size?

Michael Rubin

Yes, we're definitely not seeing any change. If I look at the pipeline, I think if anything the partners are continuing to get bigger on an average size perspective. I think what you get in any given year is a different combination.

I think Mike mentioned and this is completely shocking to me. This year, year to date we have had six -- we have done six deals for nine plays, they are all full-service. Last year, the mix didn't all look like that.

This year, you had a couple startups for some really big companies that -- I think three of the six companies are all big companies that are doing startup e-commerce businesses. So I think that at a high level, from a macro perspective, the type of partners that GSI are talking to today, if we look at our pipeline, are definitely bigger than they ever been.

We are in discussions with partners that are bigger than our largest individual partner today. I think that is going to continue to be the trend that we have.

Saying that, in any given period, if you look at in a quarter or a couple quarters, I think you'll see outliers, like the six full-service partners this year. Last year like inventories (inaudible) loss that was one partner that certainly skewed the numbers the other way.

But overall, certainly seeing great companies, big opportunity and certainly companies that would not have considered us a year ago are certainly considering us today because of the success that we have had and the size of or the overall business that is moving through our platform.

Mark May - Needham & Company

Okay, thanks a lot.

Michael Rubin

Thank you.

Michael Conn

Great, thank you everybody. We look forward to talking to you on our third-quarter results conference call.

Operator

Thank you very much, sir, and thank you, ladies and gentlemen for your participation in today's conference call. This concludes your presentation and you may now disconnect. Have a good day.

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Source: GSI Commerce Q2 2007 Earnings Call Transcript
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