GSI Commerce Inc. Q4 2005 Earnings Conference Call Transcript (GSIC)

| About: GSI Commerce, (GSIC)
This article is now exclusive for PRO subscribers.

GSI Commerce Inc. (NASDAQ:GSIC)

Q4 2005 Earnings Conference Call

February 15th 2006, 4:45 PM.

Executives

Michael Rubin, Chief Executive Officer

Michael Conn, Chief Financial Officer

Analysts

Shawn Milne, Friedman Billings Ramsey

Aaron McCann, Goldman Sachs

Mark May, Needham Company

Cornell, Bear Stearns

Paul Beaver, Piper Jaffray

Jim Friedland, SG Cowen

Operator

Good day, ladies and gentlemen. Welcome to the Fiscal 2005 Fourth Quarter and 2005 Fiscal Year Operating Results of GSI Commerce. My name is Patrick, and I will be your coordinator for today. At this time, all participants are in a listen-only mode. We will be facilitating a question-and-answer session towards the end of today’s call. If at anytime during the call you require assistance, please press “*” followed by “0” and an operator will be happy to assist you. As a reminder this conference is being recorded for replay purposes. And I would like to turn the presentation to your host for today's call, Mr. Michael Conn, GSI Commerce's Chief Financial Officer. Please proceed, sir.

Michael Conn, Chief Financial Officer

Thanks Patrick, and thanks everyone for joining us today, and good afternoon. Welcome to GSI's fourth quarter and year-end conference call for the year ended December 31, 2005. This is Michael Conn, GSI's Chief Financial Officer, and I'm here with Michael Rubin, our Chief Executive Officer.

First let me comment on forward-looking statements. All statements in the 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 and the industries and markets in which the Company and its partners operate. 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 effect GSI's business, financial condition and operating results are discussed in its filings with the SEC. GSI Commerce expressly disclaims any intent or obligation to update these forward-looking statements.

During this call, we will also present certain non-GAAP financial measures, including adjusted EBITDA and merchandize sales, and certain ratios that use these measures. In our Form 8-K, which is located on the website at www.gsicommerce.com in the Press Room section, 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.

With that, let me start by discussing the fourth quarter in more detail and I also want to touch on some of the full-year highlights. At high level, I would say the fourth quarter was very good from the prospectus of the strength of business, platform enhancements and development of future growth opportunities, slightly disappointing from the perspective of operational costs and also a little bit clouded by a couple of non-routine events that fortunately are behind us. Net revenue on a GAAP basis for the quarter was up 27% to LY and was above plan. Non-GAAP merchandised sales or total transaction volume to our platform increased to 42% versus LY and also it was above plan, and this compares favorably to industry growth of 24% according to Comsquare. The quarter actually got off to a little bit of a slow start for us, both because some of the delays in launches as we previously discussed, as well as the somewhat sluggish spending environment that we saw relative to our expectations.

Some of this, I think was really to the planning mix on our part. In the year ago, in the early part of the quarter, we really had strength driven by the Red Sox World Series victory, which was a major license products event for us, and also a very successful electronics product launch. I think what happened was we really underestimated the impact of those events on a comparable sales basis for us. I also would say that in October, also into early November, we really did see somewhat of a bit of slowness in the overall online spending environment. The second half of the quarter really was a different story. First, we completed our planned launches, and then what we saw was really just an explosion in business, and a strength of business to just staying throughout us, with us through the peak holiday period. Strength was fairly broad-based but I would highlight a few categories that were particularly strong, notably apparel, health and beauty, home and sporting goods.

Growth drivers varied by partner, but there were some interesting common themes that are worth highlighting. First, online marketing-driven transactions were notably strong, particularly search. Promotional activity clearly was important in the quarter, and there were some enhancements that we made to our platform that really made an impact for some of our partners. Couple of noteworthy ones being time-based promotions, which enabled specific time period sales, like a three-hour only private sale for one of our partners. Also, the ability to create private sales for specific user groups some of our partners took advantage of during the quarter. Alternative payments also emerged as a growth driver for our partners during the quarter. We implemented Bill Me Later and experienced good results on a number of our sites and we see alternative payments as a continued area of opportunity for us going forward. Lastly, I would highlight continued growth from gift cards as a noteworthy trend.

Overall, I would say the 42% growth in merchandise sales is something that we feel good about. It reflected a continuation of the strong underlying same-store trends that we have consistently seen, and it also marked a re-acceleration in overall growth as we generated meaningful contribution from new sites. I think that the story for us around strong growth of e-commerce and the continuing shift of online spending to leading offline companies with strong multi-channel presences was very evident in consumer spending patterns in the quarter. Our strength in volume held up through the gross margin line, a solid trend in sporting goods where our merchants have done a phenomenal job in inventory management, as well as strong service fee growth, helped us achieve a solid year-over-year increase in gross margin percent and that came in at 43.1% versus 40.9% last year. The growth that we achieved in product sales against the decline in year-end inventory versus last year is something we're really excited about.

Sales and marketing expense were an area of disappointment for us with fulfillment expense being a notable disappointment from a cost perspective, and drove what I referred to earlier, I mentioned that operational expenses were more than we had planned for. The challenge we faced in the fourth quarter was driven by slower than planned start, followed by sales explosion of a magnitude we just hadn't seen before in our business, with sales slow earlier in the quarter, we tightly controlled labor levels and our fulfillment operations, and with business ramps far faster and greater than we would have thought, we really had to scramble to hire enough people to get packages out the door. Fortunately, we were able to service our partners and consumers very well and meet our service level commitments, but the higher use of temporary labor and overtime hurt our efficiencies during the peak period.

For the owned inventory part of our business, where we did soften up some online marketing expenditures, we spent slightly more than planned, but really we offset this with better performance on freight rates where we achieved strong buying efficiencies. Overall, our ROI on online marketing spend was efficient and we delivered value to our partners in this area as well. Product development expenses, as we previously discussed, were impacted by partner launches being late, payment slightly over-budget, but relative to our most recent guidance this was mostly inline with what we thought although a bit higher than we hoped. The good news here is that we're back on track with partner launches and our new sites are performing well and we remain excited about the prospects of these deals.

We continue to enhance our long-range technology planning so we can better optimize our mix between full-time domestic resources and contracted resources, both onshore and offshore and also better smooth out our development work for the year. At the same time, technology remains an important area of differentiation for us, and we will continue to invest in areas where we think we can generate strong returns.

Our G&A expenses were clouded by a couple of items as I mentioned a moment ago. First, during the second half of the year, we pursued a strategic acquisition. Without going into detail, I will just say there was a company we thought would be a good fit with us. We spent a good deal of time conducting due diligence, and working on a deal. Part of the process involved engaging professional advisors in a number of areas. At the end, we decided for a number of reasons, the deal was not right for us, and we chose not to move forward with it. The bottom line is that we're committed to taking a disciplined approach to acquisitions. Had we completed the acquisition, our external costs would have been accounted for as part of the deal costs and would have been recorded to goodwill. Because we chose not to move forward with the deal, which was a decision we made at the end of the year, we expensed our accumulated external costs associated with this deal in Q4, and these costs were about $1.5 million. The other issue clouding G&A expenses in the fourth quarter was professional fees that related to the restatement of our prior financial results. Overall, this is about $700,000 during Q4, about 200,000 of which was greater than what we had planned for when we last issued guidance.

Finally from a net income perspective, we recorded an income tax provision in the quarter for $321,000. This primarily related to state tax obligations in Pennsylvania where there is a limit on the annual utilization of NOLs. Then when we issued our guidance, we do not expect to record any income tax provision, but in reality this was just a forecasting miss on our part and we do plan to invest in incremental tax resources to better manage our exposure as we move forward to what we expect to be a period of sustained profitability. I would also add that we have received formal approval for a $3 million tax-free grant from the State of Pennsylvania to help us offset the cost of our new headquarters that we purchased and occupied in 2004. We worked hard for almost two years to pay these grant and it's something we're excited about. We expect to receive the $3 million in cash in the first quarter of this year. While this will not have an income statement impact, it certainly helps put our $300,000 tax obligation in perspective.

Overall, profitability for the quarter showed strong growth. Adjusted EBITDA grew 11%. Again, when you exclude the deal costs and the restatement-related expenses, the growth rate would have been more than double of that, and adjusted EBITDA as a percentage of net revenue declined a little bit in the quarter but again, excluding the expenses would have been about flat and solid double-digit levels. And we have net income growth of 17% for the quarter, which was also impacted, not only by the deal costs and the restatement expenses, but also by the taxes that I just mentioned.

For the full-year, we posted net revenue of 440 million, which is up 31% to LY and merchandise sales of 682 million, which are up 44% to LY. Net adjusted EBITDA about 21 million, just up a little over 50% from last year and adjusted EBITDA as a percentage of net revenue was 4.7% versus 4% last year. Net income of $2.7 million and after excluding the 1.5 million at deal costs, the $200,000 of greater-than-expected professional fees related to the restatement and the $300,000 of unexpected income tax expense was really bottom line with our most recent guidance of net income for the year of approximately $5 million.

Our balance sheet and cash flow performance was strong for the year. Cash flow from operations was a little over 24 million versus 21 million last year, driven by strong adjusted EBITDA growth and also working capital was a source of $3 million of cash for the year. As I noted earlier, we had strong inventory management, inventory turns increasing 6 for the year, versus 5.5 last year. Capital expenditures for the year were approximately $30 million and that compared to approximately $35 million last year. Cash and marketable securities increased 157 million for the year versus 75 million at the end of '04. This is primarily due to the concurrent offering of convertible debt and common stock that we completed in the second quarter of '05. Net of debt, cash and marketable securities at year-end were 86 million, versus $62 million last year.

Looking to our guidance for 2006, we're looking for similar trends to those we saw in 2005, with net revenue expected to grow 20 to 25%, and merchandise sales expected to increase 32 to 39%. Looking for a growth in adjusted EBITDA of 45 to 69%, driven both by sales growth and margin expansion. Variable operating efficiencies and G&A should drive the margin expansion. For net income, we're looking for growth of 92 to 285% and the bridge between adjusted EBITDA and net income should be comprised of depreciation and amortization of approximately 19 million, stock-based compensation of approximately 7.5 million, net interest income over approximately 2.5 million, and an income tax rate of 5 to 10%, although we would hope to do better than that. The increase in stock-base compensation expense is driven by the expenses of stock options and our shift to restricted stock grants instead of options in response to this accounting change.

We do recognize our guidance is below current consensus expectations. Let me say a couple of things. First, we feel good about how our business performed in 2005. Our revenue growth was strong, we showed solid leverage through expanding margins and our balance sheet management and cash flow performance was really good. We face a continuing challenge of expanding margins while continuing to invest to support our growth. I think that the guidance we provided contemplates strong growth and margin expansion while leaving with us the flexibility to make investments in our growth.

With respect to the first-quarter guidance, I'd note that we are up against tough comparisons in our owned electronics business and impacts our outlook for overall growth of products sales. Additionally, as is typical for us, our investments in incremental fixed overhead are made earlier in the year so that we're fully prepared when the next peak season comes around. This always makes earlier quarters a bit more challenging for us on the cost side. With that, let me turn it over to Michael Rubin to provide some additional commentary.

Michael Rubin, Chief Executive Officer

Thanks, Mike. Our growth story continued in 2005 and the successful results were reflected in both our financial performance as well as in the new initiatives we launched. Year-over-year we significantly improved our profitability, while continuing to invest in the overall strategic development of our e-commerce platform, and this is important to note, because the success of our partners' e-commerce businesses drives the success that we see in our numbers. To keep our partners' e-commerce business competitive and growing, we need to continually upgrade and enhance and add new services to our platform. Striking the right balance is important, and I think our 2005 results shows that our team is working hard to achieve the best mix.

It's also important to highlight the GSI Commerce continues to grow faster than e-commerce, which as we all know s a fast-growing industry. For 2005, we reported today our merchandise sales grew 44%, which nearly doubles Comsquare's network's forecast of 2005 growth rate of 24%. Both Forester and Jupiter have estimated the online sales have grown 18% in 2006. Today, we should guide the cause for our 2006 merchandise sales to grow between 32 and 39%.

We continue to outpace a fast-growing industry because, number one, we continue to add partners to our base and, two, we continue to offer our partners new ways to grow their direct-to-consumer businesses. In 2005, we achieved a high end of our new partner sales cast as we signed 10 new partners. 9 of the 10 are live in the platform, including Adidas, Aero Pastal, Phillson, GNC, Levis, Radio Shack, the 49ers, Zales, and the tenth, I Robot, remains on schedule launch before the end of the first quarter. For the 9 partners we launched during 2005, we will have a strong growth benefit into 2006 as we as we enjoy our first full year of sales from these partners. Our sales pipeline remains very healthy and we again expect to sign 5 to 10 new partnerships in 2006. We're excited that we are already signed our first partner this year, which is in the apparel category. I think it's reasonable to expect we could, again, be at the high-end of our new partner goal for 2006.

Our second growth driver is the initiatives we have launched to improve and expand the capabilities of our e-commerce platform, which include technology, logistics and customer care and marketing services. These initiatives enable us to generate an increased amount of annual revenue from existing partners. During 2005, we continue to invest in all of these areas which expanded our platform and provided partnerships with more tools and opportunities to grow their e-commerce businesses faster and more profitably than they can do on their own.

On the technology front, we enhanced the overall structure by completing a two-year migration to a pure Linux web environment, representing a step forward for our underlying architecture. We added and upgraded a host of new features and functionalities that both enhance the user experience and add efficiencies can with which we and our partners can operate. We maintained a particular focus on the multi-channel e-commerce experience, with development initiatives focused on in-store pick up, associate ordering systems, private label credit cards, registries, store locators, universal gift cards, interactive catalogs, and loyalty programs.

We've also added international technology capabilities through our acquisition of Asperia, which we closed this January. We'll look to round out this offering in 2006 with international logistics and customer care to third party ranges and the development of incremental marketing services. On the logistics and customers care front, we invested in building additional capacity while utilizing our existing footprint. We invested in both our fulfillment centers and expect that we will not to add a new center in 2006 to support our planned growth. In customer service, we added work at home overflow capability to enable us to provide customer care while not having to add another call center.

In marketing services, we made substantial investments as we created a separate group to provide marketing and other services to our partners and add resources to this group. This is a key area that we can add value to our partners and generate incremental growth for GSI. We had particular success in 2005 with our interactive marketing group including an award winning branding advertising campaign for one of our partners and the successful development initiative in comparison shopping integration that drove improved ROI partners. As a reminder, our marketing services group encompasses interactive marketing, one-to-one marketing, interactive design, product content services and partnerships and alliances.

In 2006, as we mentioned, we plan to continue to invest in the business, although still clearly with the focus of delivering improved financial results. In particular, we plan to spend an incremental 17 million in fixed overhead for our business, including meaningful incremental investments in technology, marketing services, and logistics, as well as overall efforts to continue to build and retain a high-caliber workforce. As part of this investment, we'll be expanding the use of our prior headquarters building, which currently houses our product content group, to support the growth of our marketing services initiatives. In addition to the incremental fixed overhead, we plan to hold capital spending at 2005 levels as we continue to invest in enhanced infrastructure.

On these calls throughout 2005, I provided many anecdotes that have demonstrated the success we are achieving with our two growth levers, adding new partners and helping grow our partners e-commerce business faster and more profitably than they can do on their own. We're able to accomplish that second part by maintaining our commitment to continually add and enhance the functions, features and services of our e-commerce platform. We can achieve this through a strategic acquisition or by creating a more effective way to advertise on our search engine. We can also achieve this through a successful e-mail marketing campaign or at multi-variative that leads to better site usability and higher conversion rates. Regardless of the form, we will continue to strategically invest in our platform because, we know that our partner's growth and ultimately our growth depends on it.

I think a great way to illustrate the success of both our new partners and existing partners and the resulting growth in our business is to look at Thanksgiving Day and the day after Thanksgiving, which is also known as Black Friday. On Thanksgiving, as I was enjoying the football games, I was very pleased to see that three of our new partners were running television ads during the games. I sent an e-mail to on my senior management team expressing my excitement that our new partners were performing well and driving a significant proportion of our business that day. The very next day, on black Friday, when some of our longer-standing partners were in their traditional doorbuster sales, I sent another note to the team saying almost the exact reverse. I was amazed at how strong the businesses of some or our longer-standing partners had performed that day. I think this is a great example of how strongly multichannel players are performing online and how we're able to provide value to our partners when they come to our platform as well as on a continuing bases.

Before we take questions, I want to take a few minutes to provide some interesting tidbits from the quarter and the year that I think demonstrate the power of the GSI platform. For our owned sporting goods businesses, both exercise and apparel categories had year-over-year sales increases of more than 75% in the month of December. Helping drive the exercised increase, we sold over a million dollars worth of one model of dumbbells with a $400 dollar retail price. In December, we sold 22,000 pairs of Helis roller shoes. One of the five largest partners experienced a same-stores online sales increase of 93% comp for the fourth quarter. We introduced a new time-based promotional functionality with a three-hour only sale for one of the partners that generate almost $1 million in merchandise sales during the 3-hour period. We sold over 150,000 licensed sports jerseys during the fourth quarter. Overall gift card sales on the GSI platform increased 164% in the fourth quarter, versus last year. GSI hosted 158 million visitors to the sites in the fourth quarter, including a peak day of 3 million visitors on December 12th. For all 2005, we just hosted over 4 billion page views, which was an increase in 41% from 2004. For our two fulfillment centers combined we shipped just under 900,000 units for a peak week in December, close to 140,000 units and our peak shipping day, December 13th.

We continue to enhance in-store pick up functionality and during the fourth quarter, one of our larger partners showed an increase of 245%, year-over-year for the in-store pick up sales. One of our partners added for the first time an online components to their annual sample sale and enormous success, generating more than 10 times the normal volume during a few days, taking advantage of new promotional functionality we have added. Online marketing is funded by our partners and placed by GSI's interactive marketing group increased 100% year-over-year in the quarter, as we continue to enhance our capabilities in this important growth area. Bill Me Later which, is a new alternative payment system that Mike mentioned that we implement on our platform in the fourth quarter generated 5% of sales on the sites where it was offered with a meaningful higher average order value. Since integrating our automated bid management system with top shopping engines in June of '05, we experienced a 20% plus increase in revenue and a 2-x improvement in ROI.

In summary, 2005 was a strong year for us. We had strong growth from existing partners, we continue to enhance our platform including adding an international capability and we signed 10 new partners. We're off to a good start in 2006 and look forward to another great year for the Company. And with that, I would like to turn the call over to you for questions.

Question-and-Answer Session

Operator

Thank you. Ladies and gentlemen if you do wish to ask a question please press “*” followed by “1” on your touchtone telephone. If you question has been answered or you wish to withdraw your question press “*” followed by “2”. Again that’s “*” “1” on your touchtone telephone. One moment while we compile those questions, please. Our first question today comes from Shawn Milne with Friedman, Billings, Ramsey. Please go ahead, sir.

Q - Shawn Milne

Thank you, operator. Just a couple of questions Michael and Michael. If you look at what you're guiding to 30 million to 35 million in EBITDA, it looks like the incremental EBITDA guidance is about 12% if you kind of ignore the one-time items in Q4 of '05. What are you thinking about longer-term if we carry that to '07? If I use that number, I get it in the low '50s in EBITDA in '07 or do you see another step function up in fixed overhead? And I have a follow-up.

A - Michael Conn

Yeah, I would say, I think that, you know, without specifically, you know, trying to attach ourselves to '07 guidance, I think you're thinking of carrying that forward is reasonable. I think, you know, from a longer-term perspective as you look at our business we think that the potential clearly exists for even higher incremental EBITDA margins. I think that what we've talked about right now is just a focus on balancing both improving the margins with the right amount of investment just based on the growth we're seeing. I think that certainly, you know, that is a reasonable way of thinking at it and we would hope that there is an opportunity to do better, although I wouldn't want to necessarily create the expectation for '07. But certainly it's an opportunity to do better on the incremental EBITDA margin basis for this business and inherent in this business over time.

Q - Shawn Milne

Secondly, the 17 million would be higher than we expected, in terms of stepped-up investments. Can you give us a better sense of where it's going, and specifically, if you build out the interactive marketing agency. Could you envision a time when this was segmented out separately to see the EBITDA margin in the core business and how much you're investing there? Ultimately, that could be a higher margin business down the road. Thanks.

A - Michael Conn

I think if you look at the $17 million, and it is spread across a number of areas. It's the marketing services is getting the biggest chunk of it, between a third and a half of that incremental investment I would say is in the marketing services area. Don't have a plan to break that out at this time. We look at that as an integrated part of our platform, but we will evaluate that as the business evolves. I think in terms of the amount of incremental spend, you know, relative to what we would have expected, a lot of it is dependent upon the overall tone of the business, it's something we feel good about and I think we will continue to evaluate spending levels based on the trends that we're seeing in our business in particular and the overall online environment.

Q - Shawn Milne

Okay, thank you.

Operator

Thank you. Our next question comes from Anthony Noto with Goldman Sachs. Please proceed.

Q - Aaron McCann

Hi there. This is Aaron McCann for Anthony Noto. Just a couple of questions. I wonder if can you break out the contribution of new partner growth in the fourth quarter for us so we can get a sense of the core business and how it grew. And then also, as it relates to the '06 revenue guidance, how many partner deals are you assuming in that guidance and have you changed or at all adjusted kind of the schedule in which you hope to roll those new partnerships out in '06. Thanks.

A - Michael Conn

Sure, as far as new partnerships, again, it's not something that new partner contribution, not something that we break out specifically, but I would say, really if you look at the third quarter results, we had virtually no benefit from new partners and merchandise sales were mid-20s. That type of underlying, you know, growth carried through into the quarter, so if you look at the incremental growth where we were up in the 40s for the quarter, I think that can you attribute the balance of that as a decent sort of back of the envelope way of thinking about things to the partners. Overall, I would say growth was fairly well-balanced between existing and new for us in the fourth quarter.

Our '06 guidance, we're thinking about again 5 to 10 partners for the year and we have based our '06 model on that assumption. Typical for us with new partners is, you don't get a tremendous amount of contribution from new partners during the year as they tend to layer on during the year and they're more meaningful impacted the following year. As Michael was mentioning in his comments, the benefits that we have in '06 is those 9 partners we launched during the year in '05 we'll have for the full year of '06. If you look at our guidance range for 2006, even without new partners we think we can be within that range and certainly, you know, contribution from new partners in line is what we're looking for, you know, gives us a solid lead within that range.

Q - Aaron McCann

Okay, and just one follow-up question. As it relates, I know that you have referenced a cost per launch in the past of around $1million. Is there any update to that, you know, now that you're rolling out some of the, you know, additional services on the interactive side and the complexity of the deals is increasing.

A - Michael Conn

Yeah, I mean, we certainly saw some pressure on that number in 2005. The deals were larger, more complex and I think that we saw that when talked about that on our last conference call. Without putting a specific, you know, dollar figure on that, you know, certainly it was higher than that $1 million range of 2005. And from a planning perspective, that's something that we carried forward into our thinking about 2006 going forward. I think there is some good news in that. The larger average deal size certainly has a benefit for us. Certainly, there are, you know, additional complexities to deals. It's probably less driven by the marketing services components to that. That's more easily plug and play. What is driving the complexity of the deals in a lot of the multi-channel integration we're doing, the new features and functions that we're developing, sometimes really as a part of a specific deal, although it becomes a platform capability for us. It's really more on the technology side that we're seeing pressure there as it relates to the complexity.

Q - Aaron McCann

Okay, great. Thank you.

A - Michael Conn

Yes.

Operator

Thank you. Our next question comes from Mark May with Needham Company. Please go ahead.

Q - Mark May

Okay, thanks for taking my questions. A follow-up to Shawn's question, as you're investing in the marketing services capabilities, just wanted to get a sense of how many of the customers are using those services to date and maybe give us a sense of how much activity that you're doing in that area in terms of, I don't know, the amount of media that you're buying or however can you gauge that. And then the other question is, I think in Michael Rubin's prepared comments, talked about growing faster than the overall e-commerce market, that your numbers are obviously skewed a little bit by adding new customers and things like that. I'm wondering can you give us a sense of the organic growth in your commerce business. Thanks.

A - Michael Rubin

Sure. As it related to how many partners are using us for marketing services, I would say that probably two thirds are using us today to place their online advertising. As it relates to how much marketing it's been replacing, the comment I made is in the fourth quarter of '05, it was up about 100% from the fourth quarter of '04 and we see that trend continuing at that percentage basis or maybe even accelerating in 2006. So, I wouldn't be surprised of the marketing spend we place for partners, more than doubles again in '06 in absolute dollars with a bigger base than it was in 2005. Certainly, it's an impressive number that's going up and it makes sense if you think about it from a high level. It's the traditional brands and retailers that are shifting small percentages but big absolute dollars from their online, their overall marketing budgets to the online space.

The second part of the question as it's related to organic growth, I think that, you know, as Mike indicated in the third quarter, we were in the low 20s, which is basically a comp, because we didn't have any launches during that period of time and I think in the fourth quarter we were around low 40s and half was comp, half was new partners. So, we feel like we're at or above the overall growth rate of e-commerce for our existing partners and we had some real success stories. One of the things I was most proud about in the fourth quarter is some of our oldest partners that have been with us the longest had the biggest businesses, also some of the biggest accelerations and some of the most meaningful comp store growth. So, we felt the business was healthy as it's ever been from the top-line perspective and on the big of the base of business as well.

I think we can take the next call at this point?

Operator

Certainly, sir. We'll now move to Bob Peck with Bear Stearns. Mr. Peck, please proceed.

Q - Cornell

Hi, this is Cornell for Bob. Quick question on the balance sheet. We found that inventories and accounts payable were significantly below our expectations. Given the increase in revenues, one would expect a higher increase. What happened there?

A - Michael Conn

First of all, as we mentioned, we really did a phenomenal job on inventory management. I think some of what Michael was hinting at in his tidbits showed you the volume we moved during the quarter. That was really good news. If you look at just even the comments last year when we had a build in inventory during the course of the year. Some of that was related to just some build related, partner activity that we had and, you know, indicated the anniversary, why we were really able to, you know, to achieve part of that. Overall, you know, do more sales with, you know, effectively less average inventory, more than anything just speaks to just real strong inventory management on behalf of the Company.

Q - Cornell

Oh, great. And have a quick one on key word pricing. What are the trends that you're seeing there?

A - Michael Rubin

Clearly key word pricing is continuing to go up. I think it's something that is I think it's something that is a strategic risk for pure play e-commerce company, a benefit and an opportunity for GSI. If you look at our business, we're in the business of serving the big established manufacturers and retailers. These are the companies that have, many of our partners have $100 million plus marketing budgets and they're allocating for the first time 2% or 4% of the overall budge to go online. I think it's really our partners that are moving the search for the first time and driving some of the prices, but clearly prices are going up. We don't see any resistance from our partners with those price increases, because it's still a much better return than what they're getting from traditional media.

Q - Cornell

Are you seeing a lot of trend towards hitting the tails in terms of key word?

A - Michael Rubin

I'm sorry, could you repeat the last question?

Q - Cornell

Are you seeing a bigger trend of like when the partners spend search dollars, or dollars on search. Are they looking to get more words on the tails?

A - Michael Rubin

There is no question, we're expanding, I think today just to put it in perspective of our total online marketing that we spend, about 60% of that is spent within search and we're buying over a million individual keywords today on behalf of our partners. So certainly they continue to broaden the list of keywords that they buy all through the tools that we have created for them.

Q - Cornell

Great. Thank you so much.

A - Michael Rubin

Thank you.

Operator

Thank you. Our next question comes from Aaron Kessler with Piper Jaffray.

Q - Paul Beaver

Hi, this is Paul Beaver for Aaron Kessler. Two quick questions. One, just a follow-up on the key word pricing. Can you comment on the ROIs that you're seeing or ROIs improving or deteriorating? And the second question is with regard to a 17 million incremental spending, is any of that being capitalized or is that all operating expenses?

A - Michael Rubin

Sure, I'll get the first part of the question and Michael on the second part of the question. As it relates to ROIs on the keyword pricing, we see overall rates go up and able to maintain average similar ROIs good for the investments we're making in, better tools to go out and do that with, and again, people ask for why a perspective partner working with GSI versus someone else. We have a completely integrated solution, and because we're an expert buying e-commerce advertising and we're investing technologies and tools to go out in place of the online advertising, particularly search and we do in on a very ROI basis, I think we are able to get better returns. We're pleased and the partners were pleased with the ROIs in 2005 and continue to be in 2006 and that's taking it into consideration the incremental or the increasing prices.

A - Michael Conn

And the second part of the question, the $17 million, is $17 million all expense for us on operating expenses for us. In addition to that, Cap Ex we're looking at to be 25 to $30 million. It was about $30 million in 2005. You know, were we not in investment mode, we really would have looked for capital expenditures to come down in 2006. Some projects as Michael mentioned, like Linux, projects an example were things that we're rolling off of, theoretically, would have created capital spending in. Instead, we're holding it flat, so there's kind of an implied underlying increase in there, even though it's being held relatively flat. But the $17 million is pure Op Ex.

Q - Paul Beaver

And you mentioned a third of it was for the marching services. How much of that is for international?

A - Michael Conn

International is a small component based in there. I think we have closed the acquisition of Asperia. We have got a number opportunities that are in our pipeline related to that that we're excited about. But we continue to really have the same philosophy that we've been articulating, which is we're going to take a slow approach there and invest sort of as that business evolves. So from plan perspective, pretty modest in terms of marketing services, planned spend related to international.

Q - Paul Beaver

Okay, thank you.

Operator

Thank you. Our final question for today comes from Jim Friedland with SG Cowen. Please proceed, sir.

Q - Jim Friedland

Thanks, two questions. First, as you sign up some of these bigger partners with bigger brands, are you seeing the fees or as a percentage of revenues come down, just given that some of them may already have businesses or that they are such big companies that they can just extract lower pricing? And the second question is if you look back at some of your partners that have been around for awhile, say the Class of 2004 or the Class of 2003, what type of EBITDA margins are they generating, have they reached their full potential yet, you know, so we can try to figure out to get a sense of when we start to see leverage kick in on the margin side of the business. Thanks.

A - Michael Rubin

Sure. I'll answer the first question, leave the second part to Michael. As it relates to the fees that we're getting from the newer partners, the bigger partners, I think the biggest fundamental difference that's happening today is up until 2004, we only sold a complete solution and now, we'll sell a solution that for one partner could be technology fulfillment, for another partner could be technology and customer service, for another partner it might be just technology. We have brought several partners in 2005, Radio Shack, Zales, and Adidas, where we're not doing the complete solution for them. Just by its nature, if you're not doing the complete solution, the effective increase from that partner is a lower percentage of sales. Also with the same lower costs that would go with less of a solution. On an apples-to-apples basis, I would say the fees are equivalent to where they have been. Sometimes you can take a bigger piece of business, but might be a little bit smaller in the percentage base absolute dollars, it's probably more meaningful. On an absolute basis, comparing apples-to-apples, it's pretty comparable.

A - Michael Conn

Sure, and that second part of your question on the partner-level margins, I think, clearly as partners stay in our platform, they become really on a continual basis, increasingly profitable for us, provided that they're experiencing strong growth, which happens in most but not all cases for us. As far as have we sort of hit peak profitability for our existing partners, I think that the best thing to think about there is what Mike was talking about in his comments when he mentioned one of the larger partners which, is, you know, again for our larger partners in a lot of cases, partners who have been around for awhile, had a 93% comp for the quarter, so can you imagine the kind of leverage when you get a partner experiencing a 93% comp. So, you know, really don't think that at all we have reached the maximum profitability with partners that have been out of the platform for awhile. I think the key to also think thinking about profitability comes to how we allocate some of our central expenses. If you look at the incremental investments we're making to fixed overhead, it's really not partner specific, but more enhanced features and functions. But certainly, as we look at partner profitability, we also look at allocating the expenses out to partner. I think there are certainly some pressure as we invest incrementally in terms of how we look at partner profitability, but the reality is that as our partners continue to experience strong growth, you know, underlying margins improve significantly, and certainly for those partners that have been on our platform for a while, the type of profitability levels that we're achieving from them are certainly at a nice amount greater than our overall profitability levels for the Company.

Q - Jim Friedland

And maybe can you give us an example of like some of the ones that are doing really well that have been around awhile that are, you know, relatively, materially more mature than others?

A - Michael Conn

I think it's sort of always been our practice. We try not to single out by names specific partners. But I think that it's broad-based. It's not a specific category, it's not a specific type of partner, you know, we are certainly seeing strength in partners across categories, we are seeing strength in partners that are brick and mortar retailers, as well as some of the brands that we're operating and some of the licenses that GSI operating. I would say that there is just a lot of strength that we see in a number of different areas so that there is not sort of, type of area that I would highlight.

A - Michael Rubin

I mean one last thing to add, I could think about a few brick and mortar retail partners that we had that started with us either as start-up business or very small business, but comps smaller than $5 to $10 million businesses when they started. Today, they're, you know, $50 to $75 million businesses and we look at the businesses having the potential to be $250 million individual businesses in another five years plus. So, we certainly think to Mike's point that while the business has grown a lot thinking there is still tremendous growth ahead on the same-stores sales basis for these partners, which is why we continued to get more profitable for us as time goes on.

Q - Jim Friedland

Okay, great. Thank you.

Operator

Thank you, ladies and gentlemen, this does conclude the question-and-answer portion of today's call. I would like to turn the presentation back to Michael Conn for any closing remarks.

Michael Conn, Chief Financial Officer

Again, we look forward to speaking to everybody after our first quarter results, and thanks for joining us today.

Operator

Thank you, ladies and gentlemen, this does conclude today's presentation. Have a good evening.

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

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

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