GSI Commerce, Inc. Q2 2008 Earnings Call Transcript

GSI Commerce, Inc. (GSIC)

Q2 2008 Earnings Call Transcript

July 23, 2008 4:45 pm ET

Executives

Michael Conn – EVP of Finance and CFO

Michael Rubin – Chairman and CEO

Analysts

Brian Russo – Banc of America Securities

Shawn Milne – Oppenheimer & Co.

Christa Quarles – Thomas Weisel

Jennifer Watson – Goldman Sachs

Matt Schindler – Merrill Lynch

Herman Leung – Deutsche Bank

Sameet Sinha – JMP Securities

Jim Friedland – Cowen & Co.

Colin Sebastian – Lazard Capital Markets

Ross MacMillan – Jefferies & Co.

Mark May – Needham & Co.

Presentation

Operator

Good day ladies and gentlemen and welcome to the second quarter 2008 GSI Commerce Incorporated earnings conference call. My name is Shawnelle and I'll be your coordinator for today. We will be facilitating a question and answer session towards the end of this conference. I would now like to turn the presentation over to your host for today's conference, Mr. Michael Conn, GSI's Chief Financial Officer. Please proceed.

Michael Conn

Good afternoon everyone. Welcome to the GSI Commerce conference call for the 2008 fiscal second quarter ended June 28, 2008. I'm Michael Conn, GSI's Chief Financial Officer, and I am here with Michael Rubin, our CEO.

Before we get into the results, I'd like to make the following remarks concerning 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, confident, and other 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 forwardlooking statements.

During this call, we will also present certain non-GAAP financial measures, non-GAAP net revenues, non-GAAP income from operations, and free cash flow, and certain ratios that use these measures. In our Form 8-K, which is located in our website at gsicommerce.com under SEC Filings, you will 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.

Now, I will cover some prepared remarks and then Michael Rubin will join me for questions and answers.

Our second quarter performance was excellent. Our strategy ahead is well positioned, we executed strongly, and industry trends were favorable; clearly a winning formula. Net revenue growth was close to 50% and nicely above our guidance range. Non-GAAP income from operations of $6.7 million significantly exceeded our expectations and was meaningfully greater than our previous best non-fourth quarter non-GAAP operating income performance of $3.8 million.

Capital expenditures are trending below our internal plan and we are revising our capital expenditure forecast for the year to $65 million from $70 million which we believe positions us well to enhance our free cash flow for the year and highlights our focus on capital efficiency.

With this earning release, we changed our income statement presentation and introduced a new non-GAAP revenue metric. The goal of these changes is to enable investors to analyze us in a consistent manner with how the business is managed internally and one that is more comparable to that of our business and technology services peers. We have received feedback from investors that GSI can be a bit confusing to analyze because a portion of our revenue is recorded gross and a portion of our revenue is recorded net. A little background is helpful

We began in 1999 as an owned inventory company and recorded revenue from transactions at a gross basis. Beginning in 2001, we added a non-owned inventory business and recorded revenue on a net basis as service fees for those transactions. In other words, on a retail transaction, we owned a percentage of that transaction and we recorded as net revenue.

As a result, in 2003, we introduced a non-GAAP revenue metric called merchandise sales. We used the merchandise sales so that all revenue transactions could be viewed on a comparable gross basis regardless of whether these transactions were from an owned or non-owned inventory business. Meaning, it was the retail value of all transactions through the platform.

Beginning in 2006, we started our marketing services and international growth initiatives. This new service fee revenue stream was driven more by activities as opposed to e-Commerce transactions and was not able to be grossed up. With growth in these two areas along with the acquisitions of Zendor, e-Dialog, and Accretive Commerce which also earned revenue on an activity basis, a meaningful portion of the company's revenue was no longer able to be grossed up. As a result, we stopped disclosing merchandise sales as a metric at the end of 2007.

Internally, beginning in 2006, we began using a new adjusted revenue metric. Similar to merchandise sales, it enabled all transactions to be viewed on a comparable basis but in this case by netting product sales revenue down instead of grossing service fees up. In addition to enabling the company to view all revenue transactions on a comparable basis, this new non-GAAP revenue metric also allows the company to compare its revenue, margin and costumer concentration trends in a manner that more closely approximates from other business and technology services companies report their results.

To calculate the metric, we subtract certain variable expenses that relate to owned inventory transactions from that revenue. This includes cost of products which the company has historically reported as a separate expense line and marketing expenses, which include the company's expenses for revenue share payments to owned inventory partners and also includes third party shipping subsidy, catalog costs, and net online marketing costs. These marketing expenses historically have been included as a component of the sales and marketing expense line item.

But beginning with our earnings release today, they will be broken out as a separate expense line. The remaining expenses that historically have been included in sales and marketing primarily include account management fulfillment, call center, order processing, and buying. These expenses are now referred to collectively as account management and operations. As always with nonGAAP metrics, the purpose of the disclosure is to provide additional information and not as a substitute for GAAP numbers. More details of reconciliations related to this information are contained in the Form 8-K we filed today that is available on the SEC website.

Now let me cover the quarter and our outlook in more detail. Net revenue increased 47% to $193.2 million from $131.3 million. This was comprised of 20% growth in product sales, which includes freight and 104% growth in service fees. Comparable store activity was strong throughout the quarter and better than overall reported industry growth rates. Product sales growth of 20% was an accelerated rate of growth from the 13% we reported in the first quarter and was fastest growth in product sales since the fourth quarter of 2006. Similar to the first quarter, we experienced strong results from our professional sports league business, mixed results from general sporting goods, and weakness in electronics, although in all three of these cases, the trend improved compared to the first quarter.

Service fees more than doubled to $86.2 million from $42.3 million, driven by contributions from the three acquisitions made since mid-2007, strong growth in comparable store activity, the addition of new partners, and organic growth in marketing services and international. Strong e-Commerce service fee categories included apparel, toys and baby, health and beauty, and jewelry. Service fees represented 45% of net revenues in the quarter compared to 32% last year. This is the first quarter in our history where service fees represented more than 40% of net revenues.

Non-GAAP net revenue increased 85% to $102.9 million from $55.7 million. Non-GAAP net revenue grew faster than net revenue because service fees grew at a rate greater than product sales, which reflects our continued transformation into a company that is primarily viewed as a business and technology services organization as opposed to a retail company.

Cost of product sales increased 19% compared to the 20% growth in product sales resulting in a 60 basis point improvement in product margins. The increase in product margins reflected higher year-over-year sporting goods margins and favorable mix with sporting goods increasing as a percentage of total product sales and electronics decreasing as a percentage of total product sales.

Marketing expenses increased 22% to $11.9 million from $9.7 million. Marketing expenses grew at a greater rate from the 20% growth in product sales because of faster growth in professional sports leagues which have higher revenue share rates. Marketing expenses excluding partner revenue share payments grew essentially in line with product sales.

Account management and operations expenses increased 82% to $57.5 million from $31.6 million. More than 60% of the growth from this expense line directly related to the three acquisitions we've made since mid-2007. The remainder of the growth was primarily driven by higher transaction volume to the platform. Other drivers of growth in this expense line included increased investment in account management personnel, incremental costs of our new fulfillment center, and fixed operating costs related to a partner in the specialty food category that had not yet launched in the last year second quarter, though with which the company ended its relationship at the end of this second quarter. The fixed operating costs related to the specialty food partner were eliminated at the end of the second quarter and will not be a financial drag going forward.

The impact from incremental expenses associated with our new fulfillment facility in Richwood, Kentucky was less than the second quarter than in the first quarter as this facility was near completion in last year's second quarter. However, this year's results included expenses related to transferring three existing partners including two of our largest partners to our new facility. With the completion of these transfers, we are now achieving targeted capacity utilization for the new facility and we are pleased with its performance.

Product development expenses increased 67% to $25.2 million from $15.1 million. Acquisitions again were the most significant driver of the growth in this expense line item. More than 60% of the growth in the expense line directly related to the three acquisitions we've made since mid-2007 and we continue to make meaningful investments in our technology platform during the quarter.

General and administrative expenses increased 79% in the second quarter to $18.6 million from $10.4 million. More than 60% of the growth in this expense line was again directly related to the three acquisitions we've made since mid2007. Higher stock-based compensation and heavier than normal quarter of outside legal expenses also drove the increase in G&A.

Net loss was $19 million or $0.40 per share compared to $5 million or $0.11 per share last year. Company's effective tax rate for the second quarter was 3.2%, bringing its effective tax rate on a year-to-date basis to 26.3%. The year-to-date tax rate approximates what the company currently expects for its full year tax rate. The primary reason for the change in expected tax rate from the first quarter was the inclusion of amortization expense from e-Dialog and Zendor in our projected full year results.

Non-GAAP income from operations was $6.7 million compared to $700,000 last year and significantly above our guidance range of $1 million to $2 million. The key drivers of our stronger than expected non-GAAP operating income performance were above planned net revenues, better than expected improvement in variable operating efficiency, fixed expense control, and the elimination of an unprofitable partner relationship. As a percentage of the net revenue, non-GAAP income from operations increased to 3.5% from 0.6%. As a percentage of non-GAAP net revenue, non-GAAP income from operations improved to 6.5% from 1.3%.

Turning to our balance sheet, cash, cash equivalents, and marketable securities of $49.6 million were up $6.8 million from the end of the first quarter and ahead of our internal plan, but down year-over-year due to the recent acquisition activity. In the past 12 months, we invested approximately $246 million net cash to acquire Accretive Commerce, e-Dialog, and Zendor.

Inventory increased only 6% despite 20% growth in product sales. Were it not for addition of the NBA which was not in our numbers a year ago, inventory would have been down year-over-year. Free cash flow on a trailing 12 month basis improved to negative $2.7 million from negative $6.7 million. The key driver for improved free cash flow was 36% growth in non-GAAP income from operations compared to only 20% growth in capital expenditures and improved working capital benefit. This was somewhat offset with higher net interest expense.

Now, for some business highlights, we continued our strong year in business development by signing two new multiyear e-Commerce agreements. Our new partners, both of which are transitioning existing e-Commerce businesses to our platform, include a regional department store chain which signed on for a technology solution and is scheduled to launch its Web store early in the fourth quarter, and a national mall based specialty retailer of women's apparel which opted for a full e-Commerce solution and is scheduled to launch during the first quarter of 2009.

We also have four additional deals in the contract stage. We extended five e-Commerce partner deals during the quarter, including a five year extension with Polo Ralph Lauren and a multi-year extension with The Warnaco Group, which expanded its agreement to add a third apparel brand to the GSI e-Commerce platform and marketing services from GSI Interactive and an email solution powered by e-Dialog. This is an excellent example of the cross sell potential we see within our business and it has been a key rational for our recent acquisitions.

We launched three new US e-Commerce stores and two international e-Commerce stores since our last earnings report. In the US, we launched Quicksilver, Kenneth Cole, and the new Web store for Iomega. Internationally, we launched iRobot in the UK and iRobot in Germany. Year-to-date, we have launched 10 US sites and two international sites.

At the same time during the second quarter, we mutually agreed to end our relationship with a partner in the specialty foods category. As will happen from time to time, this relationship did not meet our objectives and the best course of action was to move on. We expect this termination to be neutral to modestly positive to our financial results this year, including a benefit of approximately $2 million in the second quarter and a small financial drag in the back half of the year. Beyond 2009, the absence of this deal will modestly reduce our seasonality as it was a financial drag in the first three quarter of the year due to its dedicated infrastructure which going forward has been eliminated.

Additionally, one of our partners, Linens 'n Things filed for bankruptcy under Chapter 11 during the quarter which did not have a material impact on us during the period. However, we have tempered our outlook for this partner in our current guidance forecast for the balance of the year, as the partner works through its reorganization. We expect this to be offset by increases from other partners.

Our marketing services business performed very well during the quarter, with segment revenue of $21.5 million, which was 253% increase from last year and segment non-GAAP income from operations of $3.7 million, which was 482% increase from a year ago. In both instances, GSI Interactive's contribution was up over the comparable quarter but the majority of the increase for this segment was a result of having a full quarter of contribution from e-Dialog, which was not in the last year's second quarter results.

GSI Interactive signed new business with 17 customers, including e-Commerce partners and other customers not on the GSI platform. For services that include search engine optimization, site design, paid search, affiliate marketing, studio photography, and strategic e-Commerce site assessment and planning. Included in the marketing services agreement was a significant piece of new business signed with Toys R Us, which made GSI Interactive as its agency of record and also included an e-mail solution from eDialog.

Along with the agency of record services included in this deal is a major creative project to redesign the Toys R Us and Babies R Us web stores. The creative project includes meaningful incremental fees but also utilizes development credits that Toys R Us had as part of its e-Commerce deal with GSI. Ordinarily, GSI Interactive recognizes revenue for creative projects upon completion, but because the deal combines incremental fees with development credit that are embedded in the core e-Commerce deal, we will recognize the revenue ratably over the next three years. This will shift approximately $2 million of non-GAAP operating income that was planned for the second half of 2008 into the following three years. Although, as I will note later, we are still confirming our net revenue and non-GAAP income from operations guidance for the year.

e-Dialog performed very well during the quarter, exceeding our top line to bottom line expectations. e-Dialog delivered strong growths from existing customers and signed new email services deals for eight customers. The new business wins include Oakley, Course Advisor, Lifetime Networks, and Hickory Farms. Additionally, two GSI partners, both of which we added through the Accretive Commerce acquisition, The Warnaco Group and Cost Plus World Market signed on for e-mail solutions powered by e-Dialog.

The three acquisitions we have made since mid-2007 are performing well, with second quarter performances that were either in line with or ahead of our internal expectations. We have substantially completed the integration of Accretive Commerce while spending less than planned on the integration. In our initial guidance for 2008, we expect to spend $7 million in acquisition integration expense and $11 million in acquisition integration capital. We now expect to spend $5 million in acquisition integration expense and $8 million in acquisition integration capital in 2008, which reflects a combined reduction of $5 million. However, we do plan for some modest continuing integration projects related to Accretive in 2009.

Turning to our guidance, I mentioned on our last call that as a business with over 200 partners and customers, certain occasional disruptions are part of the business. This quarter, we saw the termination of a partner relationship that was not meeting our financial objectives and a bankruptcy of a large customer. In addition, as I mentioned earlier, the revenue recognition for a large project was different than we had planned causing us to push some of the expected benefit into later years.

With that said, we're very pleased to be reiterating our guidance for net revenue of approximately $1 billion and non-GAAP income from operations of $80 million to $83 million. I believe this speaks to the strength and diversity of our business. I would also note that our guidance from loss from operations now includes acquisition related amortization expense for e-Dialog and Zendor, which resulted in a change from our last fiscal year 2008 guidance. We're also revising our capital expenditure guidance to $65 million from $70 million as we maintain our strong focus on capital efficiency while at the same time moving forward on all key investment projects.

From the third quarter, we're expecting net revenue of $188 million to $193 million or an increase of 37% to 41%, a loss from operations of $18.5 million to $19.5 million and non-GAAP income from operations of $3.5 million to $4.5 million.

Before we go to Q&A, I want to answer one question I believe is on investor's mind which is why is GSI doing so well in a difficult overall macro environment. The answer, we believe, is that we have the right strategy, we are executing well, and industry trends are favorable. With respect to industry trends, I think it is important to maintain the perspective that e-Commerce represents small percentage of sales for our partners and we believe they will continue to experience share shift from offline to online. In addition, interactive marketing still represents the small portion of our partner's advertising expense and we believe they will continue to shift marketing dollars from offline to online. We think in both cases, even in an overall tougher environment, the share shift trend is prevailing.

With that, Michael Rubin and I will take your questions.

Operator

(Operator instructions) And your first question comes from the line of Brian Pitz of Banc of America Securities. Please proceed.

Brian Russo – Banc of America Securities

Hi, this is Brian Russo for Brian Pitz. So, it seems like you had a very strong quarter and kind of when to length about how the industry trends are strong, so I'm kind of curious why you decided to keep the '08 guidance unchanged?

Michael Conn

Sure, Brian. It is Mike Conn. I think there are a couple of discrete items which I noted in the prepared remarks. I think, in general, beyond that there is a bit of conservatism built into our expectations. I would say, the guidance that we gave is really where we think are the right places to have expectations, but I think we feel good about the fact that we are there with a bit of conservatism built in. So, I think, overall we feel good about the business and we think that we have the guidance in the right place for the year.

Brian Russo – Banc of America Securities

Okay, thanks.

Operator

And your next question comes from the line of Shawn Milne of Oppenheimer. Please proceed.

Shawn Milne – Oppenheimer & Co.

Yes. Thanks for taking my question. Just a couple of them. This was probably one of the stronger quarters we have seen over the last several years in terms of what is said on the top and bottom line.

Mike Rubin, if you can just give us a little bit more color on your comp store growth in the quarter, if you want to give out that number, and secondly, why is it trending above industry growth rate? Is it a function that your partners have lower online penetration rates or is it really the fact that you are helping improve conversion rates and things like that on your site? Secondly, if you can talk about what you are seeing in terms of July comps? Has there been any kind of changes we roll in to Q3? It does not look that way with your guidance. And then lastly, just trying to piece together the EBITDA guidance from the second half of the year, should we basically assume that the Hershey's move and the sort of Toys R Us revenue issues sort of wash on the full year number? Thank you.

Michael Rubin

Sure, let me try to take those in each of the pieces. On the first part, as far as how are our comp or sales and kind of how do they compare, I think what I am going to say is that, if you look at different industry numbers, I think the most positive number that we have seen is 17% for e-Commerce growth and we are definitely nicely above the 17% and we have been consistently above the 17%. And to kind of answer the second part of your question, July has also been trending the same way. We have seen no change in July. I think it has constantly been above the average of the industry.

As far as why is that really happening, I think it is a couple of things. I think, first off, for our partners, e-Commerce represents 2% or 3% of their business on average. So, if e-Commerce doubles, it becomes 5% or 6% or maybe 8% of the business, so to certainly allow that share shift happening, I think that is something that people really miss. When people look at GSI, lots of them are like wow, we are worried about the companies you work with and in the reality, we are giant beneficiary because the shift is definitely going to happen and our partners are definitely seeing that shift happen. So, even in a really tough environment as Mike Conn kind of commented upfront, we certainly believe we are going to continue to see a lot of shift and actually doubt it is still not significant to our partners over our businesses.

I think the last part is we definitely are executing better. There are just many little things that we are doing – we are doing a better job for our partners and it is really working. Whether there was a shift impact inside of our warehouses quicker today than we did a few years ago, whether that we have got a stronger management team in place than we did a year ago, whether it is for – as an example, the license business, we started doing personalized t-shirts and fleece that we never have done before that can sell half a million units this year. So, my point is that should one of – or that was actually three or four of many example of things that we do for our partners. So, overall, we definitely believe we have got the right strategy and we are executing really well for our partners.

Michael Conn

The timing of some of the discrete items, specifically Hershey's and Toys R Us, the first one was, as we mentioned, a benefit in the second quarter but actually would be a bit of small drag in the back half, really Q4 or even though on an overall basis the relationship was meeting financial objectives as really is the case of all our relationships. There is still good contribution at 4Q, so that unwinds and is about neutral to slightly positive to us for the year but a little bit of a drag in 4Q. The Toys R Us change from an accounting perspective really is spread throughout the back half of the year in terms of what have been recorded versus what we will now record this year with the balance being pushed out to 2009 through 2011.

Shawn Milne – Oppenheimer & Co.

Great, thank you.

Operator

And the next question comes from the line of Christa Quarles of Thomas Weisel. Please proceed.

Christa Quarles – Thomas Weisel

First question is on the marketing services side. I was trying to calculate a pro forma number and I was getting around 46% and I was just wondering if that was in the ballpark there? And I guess we're hearing from our own agency contacts that e-mail spending specifically is increasing dramatically during this macroeconomic downturn and I was wondering if you have anecdotal evidence to support that. Obviously it's small within your own business still but, are you seeing a just a larger shift related to the macroeconomy. And then the third question just is around the two new agreements that you signed. Had those, you said that they were existing e-Commerce businesses, have they been working with another partner, or where those in-house, and what were primary factors that led to the win [ph]? Thanks.

Michael Rubin

Sure. I'm going to have Mike answer the question as far as the percent, the pro forma question, but I'm going to answer your second two questions.

As far as the spending on e-mail goes, I think you are definitely correct. The e-mail is increasingly – it is getting more popular. There is more spending happening. And I'd say, it's probably the most recession resistant form of interactive marketing that I believe exists. It's funny, when we went out to make the acquisition, the first thing we decided was, what are the businesses that we want to be within our interactive marketing? And we chose the e-mail space as our first space. And the reason we want to be in the e-mail business is we felt that the results, that it generate for companies that we'd worked with, the best asset average return of 50:1 for the dollar you spend in e-mail, probably 50 times, that's what you get in revenue. So when you look at that kind of ROI certainly people want to keep spending money there because the results are so great. We also realized that most company's databases are very small today; maybe they have 10% or 20% of their database online. So we felt like, with huge growth of data bases and also such a great ROI, that this was a great place to be.

One of the real benefits that we are seeing with the acquisition is that many of our partners that have used other e-mail providers are now moving over to e-Dialog through GSI. So we announced eight new partners in the quarter which I think is one of the best quarters e-Dialog has ever had. But at the same time, two of those partners were GSI partners. So I think that speaks a lot to the benefit of GSI owning e-Dialog. So we certainly feel great about the business. It is actually pretty meaningful too. You made the comment that you weren't sure kind of what it was relative to our business. It's going to be on a full-year basis a $55 million business. So it's a pretty meaningful business to GSI. And overall, the last point I want to make is that when we look at what existing partners are spending on e-mail, its definitely growing on a comp basis very aggressively. So not only are we seeing lots of new partners sign up for these services but the existing partners are spending a lot of money.

As it relates to your second question about the two partners and kind of what were they doing before, I believe that both partners were insourcing the business before and it was typical. When we look at GSI in a given year, we generally say five to ten partners, I think we generally achieved the high end of the guidance. Certainly this year we definitely believe we are going to achieve the high end of the guidance. I think you generally see a couple of partners that are starting businesses, a couple of partners that have outsourced to other people and are moving it to us, and partners that have insourced; and I think these just happen to be two of the partners that had insourced previous to – doing with GSI and felt that GSI could give them better capabilities and up and grow the business much more quickly than what they could do on their own.

Michael Conn

Just to close the loop on that question on pro forma, I think what you're trying to get at was just e-Dialog on a standalone basis and how it grew year over year. It is not something that we are specifically breaking out. It's embedded within the overall segment for marketing services. That said, I think the number you threw out directionally is certainly something that is directionally accurate.

Christa Quarles – Thomas Weisel

Okay, thanks.

Operator

And your next question comes on the line of Jennifer Watson of Goldman Sachs. Please proceed.

Jennifer Watson – Goldman Sachs

Great, thank you. Can you talk a little about how you think about controlling shipping costs in this type of environment? And then also with the international rollout of iRobot, if there were any lessons learned or hiccups that you saw in terms of rolling out internationally versus the domestic?

Michael Rubin

Sure. As far as overall shipping rates, I mean, one thing that I definitely believe and I think our partners believe is that with increasing gas prices that we certainly want to keep shipping prices very competitive and if anything, it's probably becoming a small benefit to our partners, e-Commerce businesses being at the higher gas prices – I don't want to say really benefiting; I certainly think it's not hurting the business so I think when we look at the rates that partners – whether there are partners in general or charging consumers, I think people looking to keep the rates definitely competitive for the consumer. The one thing I will say that is important, as we continue to grow, our overall spend with the shippers is increasing in the very significant way. We have never broken this out but just to give you a range, we spent nine figures in shipping this year with the shipping companies. As we keep growing that, we are getting better rates and we are helping our partners to get better rates. I think one of the real benefits of GSI and our scale is that we can negotiate better deals for shipping in total and I think that is definitely something that is going to benefit our partners to continue to stimulate revenue.

As it relates to international roll out in iRobot, I think what we are seeing internationally is that there is really not an international strategy, that's really a country by country strategy and that is why the Zendor acquisition that we made in the fourth quarter of last year is really benefiting us in that we have people in the region that understands the business, that have expertise. We are seeing that to be very valuable to our partners. So we have now brought two US partners, both the Casual Male and iRobot, to the international business in addition to the international partners that we have. Actually another partner Iomega as well and we are definitely seeing the partners not only need the capabilities but they really need the expertise because international e-Commerce is much more complicated than US e-Commerce and we think that is another part of our value proposition that we can really deliver on to our partners.

Jennifer Watson – Goldman Sachs

Thank you.

Operator

And your next question comes from the line of Matt Schindler of Merrill Lynch.

Matt Schindler – Merrill Lynch

Yes, hi, I just wanted to get a little bit more detail on not necessarily the dropping of the Hershey contract but what is the decision process when you go through for dropping or coming to a mutual agreement to walk away from a contract as opposed to something which really has not happened to you which would be a true costumer loss and what are the covenants that you have – require of your costumer to provide and was that a main determinant in whether or not you drop or walk away from that costumer. Also on a related note, what are the – just wondering if you could tell us the active number of partners at the end of the quarter. I believe it should be about 87 for GSIC.

Michael Rubin

Sure, I don't know if we have the exact accurate number in front of us, but certainly directionally that is very close. If it's not 87, it is 88 or 89 or 85 or 84. I mean, certainly in that range. We could certainly follow up with you on that separately. Without getting into the costumers specifically to your point, I think one thing that we've learned in this business today is with the over 200 costumers, our revenue basis have never been more diversified than it is today. At the same time what we have recognized is that every transaction is not going to work. If you look at the core GSI e-Commerce platform costumer base, the 86 or 87 that you were referring to, it is not common that we have a partnership that is not really working out for us, but it does happen from time to time and this was an example of that. I think if a partnership is not working, I think it's certainly something that we will aggressively address and certainly in this situation, we are a better business as a result of not having this business and that we are going to be more positive this year for not having it. But the bottom line is, it is more unusual than not. I think this has only happened a few times since we have started the company. But again, I think with 200 partners in any given year or any given period of time, there is going to be whether it is certain partners that have financial issues, or just dealer issues, or partner satisfaction issues, or specific issues like we had here. There will be some unique circumstances and of course, the best action is always to deal with it aggressively.

Matt Schindler – Merrill Lynch

Okay, thank you.

Michael Rubin

Thank you.

Operator

And your next question comes from the line of Herman Leung of Deutsche Bank. Please proceed.

Herman Leung – Deutsche Bank

Hi. Just a couple of questions for you guys, great quarter. First I guess, Kenneth Cole looked like it kind of launched earlier than expected in the second quarter. I was wondering if you can quantify some of that benefit in the second quarter. And also second question, there was the restoration services hardware facilities that also kind of shutdown in the quarter along with Hershey's. I was wondering if you can kind of quantify the cost savings between, I guess, restoration out there and I have two follow-ups.

Michael Rubin

Sure. On the first, Kenneth Cole launched in the early July, right when we expected it to launch, so there was actually no variance from a timing perspective, so it was – as a launch it went well; we're pleased with the result that there was no doubt from a timing perspective there. Restoration hardware, similarly this is a facility and a piece of that business on the fulfillment side that we've been planning to exit prior to completing the accretive acquisition, so this was known at the time that we did it. The plan has been to wind down that fulfillment piece of business sort of as the third quarter comes to conclusion. It's built within our guidance – the numbers are not something we're specifically breaking out, but it has been something that's been known and expected for quite sometime. The facility is still operational today but we will be winding down, and we would expect over the course of the third quarter.

Herman Leung – Deutsche Bank

And I guess, on your Toys R Us marketing deal that you guys have signed, can you talk about the timing of the new launch? I think you talked about some benefits that's going to be pushed out for the next few years but you have a creative project out there? I was wondering if you can talk about the timing of this new site launching and if you can kind of talk about the economics behind this deal.

Michael Rubin

Sure. As far as a specific timing, I don't think it would be really right of us to comment just because it is something that affects consumers and affects the partners; it isn't a question that I am comfortable answering. As it relates to the overall partnership, I think Toys R Us has been an important marketing services partner. With this expansion, they definitely add a lot of additional services to the marketing services relationship, made us their interactive agency record which was something that was a really great accomplishment and this was actually I think the biggest marketing services deal in the GSI interactive side that we've done in the history of GSI interactive. So certainly, we are definitely pleased with it. We think it's going to be a great relationship but at the same time, I just don't want to get into the specifics of – I don't want to get to the specifics of when it is going to launch.

Herman Leung – Deutsche Bank

Got it. And then you talk a little bit about the four additional deals that you guys still have in the contract stage right now? Do you expect to kind of close that by the second half of 2009 and if you can kind of just quickly talk about the market you kind of seeing out there by demand for some of these really kind of retailers out there for some of these e-Commerce outsourcing solutions out there? Thanks.

Michael Rubin

Sure. I mean, we definitely – I think the comment we made is that we've said five to ten new partners; we've already sign five. We did make the comment that we have four in legal right now. So, I think we are very bullish that in the second half of 2009, we'll get to the high end of the range which is certainly kind of why we made the comment. As it relates to specific services for partners, I mean, the one thing that we're definitely seeing is in a lot of ways I think a little bit of tough macro environment is definitely benefiting us and I think people are not only seeing the value that GSI is bringing to our partners but they are also seeing that this is more complicated and harder to do on their own. I think they are in an environment where we really look at costs even more critically; I think it's making our business model prosper that much more. So I think overall, we're also definitely benefiting from having a wide range of e-Commerce services and it's definitely our strategy to have a broad set of services in the US, a broad set of services internationally, and a broad set of interactive marketing services and we're seeing terrific demand really across the board. The one thing that I am probably most excited about I think we have really began to prove out during the second quarter is how we can cross sell partners. So, a great example is we went out, we bought accretive commerce and with that acquisition, we brought on Cost Plus World Markets, we brought on Warnaco, and then we went on and bought e-Dialog. You've got two accretive customers that went out and bought e-mail services from e-Dialog, so I think we're really proving that we can cross sell different services across the partner base and that is definitely something that's going to be a much bigger benefit in the future.

Herman Leung – Deutsche Bank

Thanks.

Operator

The next question comes from the line of Sameet Sinha of JMP Securities.

Sameet Sinha – JMP Securities

Yes. Thank you. Can you talk about some of the e-Commerce trends that you saw during the quarter, conversion rates, average purchase price, what sort of promotions are you working – are working for your clients? And my second question is primarily when is the CapEx coming down and can you venture a guess to what free cash flow could be for 2008?

Michael Rubin

Sure. Let me get the first part of that question. As it relates to average order, it's been amazingly consistent since we started the business in 1999 and still today, the average order is around $100 and it has been that since we started the business and it's interesting because you bring on one partner with a $200 average order, another partner with $50 average order, but when it's all said and done, the averages remain pretty constant around $100. As it relates to conversion rate, that's also been pretty consistent. I think it's grown a little bit and I think that's just from our partners and GSI executing better. So I think in a lot of cases we have seen conversion rates grow a bit although overall, I think, they are somewhat consistent to where they have been but improving, I would say, modestly but consistently.

And then the last part of your question was around promotions and I think that during a difficult environment, you will see more promotions. For us that's something that there is really no risk to because we have taken our percentage of revenue, so we're not bearing the margin risk for our partners. But even for our partners, if you look at a company, may be they have given out a port to marginally [ph] drive more business, so I think the environment is a little bit more promotional. I think free shipping is as popular as it has ever been and we will continue to see partners do a lot of things to drive the business and overall, we think it's really working.

Michael Conn

On capital expenditures, the biggest driver of the decline is integration capital which is now projected at $8 million for the year versus $11 million. I think we certainly tried to forecast that conservatively. We focused very hard on all of these integration projects, carefully scrutinizing everything from an ROI perspective and have been able to bring that number down. I think we have also carried a bit of contingency that as the year has gone on, we have been able to get ourselves comfortable that we can come in under where we were originally looking for. Even potentially, I would still say, some further opportunities, so we're very focused on capital efficiency; at the same time, we're not pulling back from growth initiatives. We're still investing aggressively in the business, we are adding capacity, so it's really not coming at the expensive of growth, not coming at any tempering of our expectations for the business, but really just much more intense focus on capital efficiency and trying to do things as efficiently as possible.

Free cash, I think the thing that has really held us back from forecasting free cash flow or providing guidance is the potential for swings in working capital, particular year end where it just a point in time when working capital can certainly move around quite a bit from just a day to day or week to week perspective. I think if you work to strip out the potential for unusual working capital swing and then if you just look at the other components of our guidance, I think you'd get back into $10 million to $15 million range of free cash flow for this year which again it's something that we think is very achievable.

Sameet Sinha – JMP Securities

Thank you.

Operator

And your next question comes from the line of Jim Friedland of Cowen & Co.

Jim Friedland – Cowen & Co.

Thanks. Just a question on acquisition strategy, having made a few and you expect a lot on the cash position going forward especially looking at building the marketing services business, are you looking to build by any additional acquisition even if they are just sort of smaller tack on or is the goal just to build it internally at this point?

Michael Rubin

No. We would definitely continue to make acquisitions, I mean I think the thing that we're most pleased about is we have gone out as Mike indicated and spent roughly a quarter of a billion dollars and bought three companies over the past year or so and we feel really great about acquisitions. I think they're meeting our objectives; in a lot of cases, they are beating our objectives and that's something that obviously anytime you go into an acquisition, you always worry about would it work and how we are going to integrate these things, and what could go wrong. So I think overall, if you ask us today, having done three acquisitions and probably the most complicated acquisition for us was Accretive which is the one that we have owned for the longest, I think we are really pleased with the results that we have had, so I said we continue to believe that the strategy we're having is the right strategy. The one thing that I would say going forward is that I think the – if you look at the three deals and see the average deal size today was roughly $80 million and should we take the three deals over a quarter of $1 billion. I think the average deal size will go down going forward and the places we are going to continue to do acquisitions will be in the same areas that we have done which is how do we get more interactive marketing capabilities, how do we get more international capabilities, and how do we continue to bring scale in the US business to really help us deliver to US better, but we certainly think that acquisitions are very important part of our strategy and we will continue to do it on a measured basis.

Jim Friedland – Cowen & Co.

Okay, great. Thanks.

Operator

And your next question comes from the line of Colin Sebastian of Lazard Capital Markets.

Colin Sebastian – Lazard Capital Markets

Thanks for taking my questions and congratulations on the quarter. Following up on some of the questions about the overall industry trends and the multichannel opportunity, can you talk a little bit about the competitive landscape there, if you're seeing any changes? And then secondly, on the marketing services side, obviously it is growing very nicely for you off a small base. Are you seeing any greater price sensitivity from your partners, from what they are willing to spend online or is it that the economy is actually pushing them to spend more and drive more traffic to their sites? Thanks.

Michael Rubin

Sure. On the competitive landscape, I would say, one of the things that I am really pleased with is that I think, we are continuing to really grow in size and I think we are continuing to further our position and kind of strengthen our position from other competitors in the marketplace. Everyone will say that there is not lots of competition in the marketplace and every year, there is new competition. There is always competition in the marketplace, but I think we feel really good about where GSI is today. I think we have never been positioned better than how we are today.

As it relates to interactive marking, I think you actually summed it up well, which is we are seeing that this medium is delivering better results. So, when you look at our partners today, although the overall industry stats say that 8% of total advertising is spent in interactive marketing, we are not seeing that with our partners today. It is probably more like 2% or 3%, so in a lot of ways, I think retailers and consumer branded companies are a little bit behind averages that you see published by Forrester and Jupiter. We think that is a great opportunity.

The bottom line is, in a difficult environment, people are as ROI focused as ever and I believe that interactive marketing by its nature is more ROI focused and gets the results. And certainly, if you look at our e-mail business, it's probably the best ROI of any of the interactive marketing medium, so we think that there's continuing to be lots of growth. The marketing services business is getting to be a pretty meaningful business today for us. If you look at us on an adjusted revenue basis, the new metric that we put up today, I think you are going to see that interactive marketing is a pretty meaningful part of that and will continue to become more meaningful over time.

Colin Sebastian – Lazard Capital Markets

Thank you.

Operator

And your next question comes from the line of Ross MacMillan of Jefferies & Co. Please proceed.

Ross MacMillan – Jefferies & Co.

Yes. Thanks. Just a clarification on some numbers. So, first, I think you signed – at the time of the first quarter call, you'd signed up three new partners, you have done two more, and you got four in the pipeline, so that is five signed of four in the pipeline? Is that the right – are those the right numbers?

Michael Rubin

Yes. That is the right calculation, Ross. But the only caveat, we have a lot more than four in the pipeline, we have (inaudible) the contractual period which generally moved to closing somewhat quickly, but certainly the pipeline is much bigger than four contracts.

Ross MacMillan – Jefferies & Co.

So, the four would be this year's signings?

Michael Rubin

We have got five to ten partners for this year and I think we are comfortable believing that we are going to be at the high ends of that guidance for signings this year.

Ross MacMillan – Jefferies & Co.

Great. And then, I just missed the comment you made on Linens-N-Things in terms of what you have done via-a-via your guidance or your assumption of their contribution for the back half of the year. Can you just repeat that?

Michael Rubin

Sure. I think what we do is on monthly basis, we go through the forecast of all of our commerce platform partners and I think what we have done is we have tempered the LNT outlook for the balance of this year. At the same time, there is a lot of partners that have come up in expectation, so overall – I think our overall partner business [ph] when you put in together was certainly in a really good place, but certainly we were more conservative with Linens-N-Things just because they are going through the reorganization process. And I think as we get bigger and with 200 overall partners today between the interactive marketing business and the e-Commerce business, we certainly believe that every year we are going to deal with partners that go into bankruptcy and have financial issues, and there is always ups and downs, but certainly the business has never been more diversified and it was pretty easy for us to temper the expectations. But Linens-N-Things would still have a very good overall outlook for the balance of 2008 and beyond.

Ross MacMillan – Jefferies & Co.

Great. And just on that point, I recall in Q1, you said that partner financial issues and other issues are part of what you face and therefore, there is always that element to your business. With Hershey's behind this and with Linens-N-Things behind this, should we assume that from an existing partner standpoint, we should see kind of stability for the remainder of 2008?

Michael Rubin

I think, it depends on how you think about it. If someone wants to stay within 200 partners, can we find a little partner that is not meaningful to us, that we are not going to move the needle and could come up with an issue. To do always things like that in the marketplace with 200 partners is just a law of numbers. I think, overall, when we look at the partners that moved the needle and drive the gross profit and drive the profitability of the business, we have definitely never been in a better position from where our relationships are, the length of the term of contracts, the healthiness of those partners, so I think overall we feel really good about the quality of the overall business. But I do not want to say that someone can come up and say partner 170 does not have a financial problem, because with 200 partners, you are always going to have that. But, again, I feel great about the overall strength of the overall business when you put it together and look at it on a concentration perspective.

Ross MacMillan – Jefferies & Co.

Yes. That's helpful. Thanks very much. Good quarter.

Michael Rubin

Thank you.

Operator

And your final question comes from the line of Mark May of Needham.

Mark May – Needham & Co.

Hi. I actually do have two questions that haven't been answered yet or asked. When I think about the synergies between e-Dialog and the rest of your business, can you may be walk us through the demonstrated lift that e-Dialog has been able to show for an average partner that they bring onboard in terms of online sales? And then the second question is for Mike, is there any chance that the Nike SKU issue could be resolved in the near future? I know you don't carry many Nike SKUs. Is there any chance that that gets resolved over time? Thanks.

Michael Rubin

Sure. Let me get the Nike issue first, as it relates to Nike, our two biggest full line sporting goods partners, which is Sports Authority and Dick's Sporting Goods which represent a great proportion of our full line sporting goods business, where Nike is important. Both carry a broad assortment of Nike today. Now, the partners own that inventory, so we may have been a little bit confused this. GSI does not buy directly from Nike, but Dick's and Sports Authority each own a broad assortment in Nike that is made available on the Web site today and I think have a very competitive assortment. That is something that changed for us in the last year or so and certainly been a nice driver to each of their businesses. So again, the partners own the inventory but we do have a broad assortment of Nike inventory for both Sports Authority and Dick's. And again, those two partners represent the majority of the full-line sporting goods business.

As it relates to the synergies with e-Dialog, we're in the middle right now of moving over 40 partners from other e-mail providers to e-Dialog and GSI, which is a process that we are currently in the middle of doing. So, I don't want to speak to the results that we've seen today. I think if you look at e-Dialog overall, we believe that they have got some of the best results of anybody in e-mail space and the average results are 50 to 1 if you look at a dollar spent versus kind of a dollar in revenue or $50 in revenue received . So, overall, I would say that e-Dialog's ranked highest by the Forrester and Jupiter and a big call on [ph] about e-Dialog is the professional services and expertise that they have in addition to a great technology, and we certainly see the partners have recognized that.

And we have seen that just as we have restarted to begin to up-sell additional GSI partners e-Dialog services, how impressed they have been with the capabilities and the services and how to benefit them. I think you saw the first part of those benefits in Q2 when we took two companies that hadn't worked with GSI for e-mail before. They are now moving their e-mail business to us and we think there's a lot more to come and we think that specifically (inaudible) results that we can have a partner to achieve versus what they could do with another e-mail provider.

Mark May – Needham & Co.

Okay. And I don't know if I'm still miffed here but if I am, I'll just keep rambling. One more question, in terms of – I jumped on late, sorry if you addressed this, you have one of your top executives that is (inaudible) for a while. Can you just talk, give some color in terms of pipeline and activities that you've seen over there?

Michael Rubin

Sure. So Steve moved to Europe last summer and I think it's really going as we expected. Our expectations upfront was that this was a really big opportunity but there was also a lot of complexity that went along with it and that's how we are really approaching it, not just from an international perspective but really from a country by country basis. With the acquisition that we have made of Zendor and with other things that we plan to do, I think what you'll see us do is the same thing that we do in the US, which is either buy companies or work with companies to find ways to cross sell services. So I think it's our expectation that you'll see us, the same way that we are cross-selling here in the US, cross-sell internationally. And we feel very good about the progress that Steve has made. I think we've made a lot of inroads in the UK. I think we've made a lot of inroads into certain other European markets. I think we've done a lot more in common. Overall, feel like – the overall expansion into Europe is going as expected and definitely expect to talk more about this in our future calls.

Mark May – Needham & Co.

Thanks.

Michael Conn

Great. Well, I want to thank everybody for joining us on the conference call and I look forward to reporting to you next quarter.

Operator

That concludes the presentation. Thank you for your participation. You may now disconnect. Have an excellent week.

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