Liquidity Services Inc (LQDT) 2007 Q2 法說會逐字稿

Good day, ladies and gentlemen, and welcome to the Second Quarter 2007 Liquidity Services, Inc. Earnings Conference Call. My name is Eric, and I'll 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 the conference.

(OPERATOR INSTRUCTIONS)

I would now like to turn this presentation over to our host, Ms. Julie Davis, Director of Investor Relations. Please proceed.

Thank you. Good afternoon and welcome to Liquidity Services, Inc.'s Earnings Release Conference Call for the fiscal second quarter for the three months ending March 31st, 2007. During this call, we will refer to Liquidity Services, Inc. as LSI.

Presenting today are Bill Angrick, our Chairman and Chief Executive Officer and Jim Rallo, our Treasurer and Chief Financial Officer. This conference call is also being broadcast through the Internet and is available through the investor relations section of the Liquidity Services Inc's. Web site.

Before we begin, I'd like to remind you that matters discussed on this call contain forward-looking statements that involve risks and uncertainties concerning LSI's expected financial performance as well as LSI's strategic and operational plans.

These forward-looking statements involve a number of risks and uncertainties that could cause actual results to differ materially from those anticipated by these forward-looking statements. These risks and uncertainties include a variety of factors, some of which are beyond our control. These forward-looking statements speak of today and you should not rely on them as representing our views in the future and we undertake no obligation to update these statements after this call.

Please refer to our SEC filings as well as our current earnings release posted a few minutes ago on our Web site for a more detailed description of the risk factors that may affect our results. Copies of these documents may be obtained from the SEC or by visiting the investor relations section of our Web site.

To supplement the Company's consolidated financial statements presented in accordance with GAAP, we use certain non-GAAP measures. These non-GAAP measures included EBITDA, adjusted EBITDA, adjusted net income and adjusted EPS. We believe these non-GAAP measures provide useful information to both management and investors.

These measures, however, should not be considered a substitute for, or superior to, GAAP results. A reconciliation of all non-GAAP measures included in this conference call to the nearest GAAP measure can be found in the financial tables included in the press release.

We also use certain supplemental operating data as a measure of certain components of operating performance which we also believe is useful for management and investors. This supplemental operating data includes GMV and should not be considered a substitute for, or superior to, GAAP results.

At this time, I'd like to turn the presentation over to our CEO, Bill Angrick.

Thank you and good afternoon. As detailed in our earnings press release, Q2 was another strong quarter for Liquidity Services. Overall, GMV grew 37% year-over-year, adjusted EBITDA grew 23% year-over-year and adjusted diluted EPS increased 25% year-over-year. Our overall strategic objective, as you know, is to develop the largest and most efficient online marketplace for reverse supply chain merchandise, and during Q2 our team achieved a few noteworthy milestones.

Q2 was the first quarter we eclipsed $60 million of GMV and surpassed 600,000 total registered buyers. The dedication and teamwork of our employees have enabled us to continue to diversity and strengthen our overall business as we continue to build the market leading company in our space.

For this release, we have added supplemental slides which we will refer to by number during our presentation. These slides are also available on our corporate Web site for anyone who wishes to download them directly.

As depicted in slide four, the mix of our business has changed dramatically. Our commercial business is now LSI's largest and fastest growing segment at approximately 48% of GMV, up from 25% in the prior year period. Our DoD surplus business now represents slightly more than 25% of our GMV, and our DoD scrap business, which we view as a separate and distinct business from surplus, now stands at approximately 23% of total GMV during Q2.

As depicted in slide five, this mix shift to commercial continues to be driven primarily by increased penetration of existing client relationships due to increasing acceptance of our E-commerce platform as an industry best practice by large corporations. We believe our approach to serving this market is stimulating increased demand for our service offering.

We achieve this by openly sharing transaction data with our clients and using fully aligned pricing models in which we share in revenue an upside created with our large sellers through consignment and profit sharing relationships.

Our end-to-end solution delivers high customer value by combining all the required services to store, market, sell, ship and pay for goods in a single offering on the Internet. Our focus on serving the needs of large sellers in the reverse supply chain is also a key competitive advantage for LSI.

With over 750,000 completed B2B transactions we possess unique knowledge, skills and data that are highly credible with large corporations. When you combine all these factors, our online marketplace enjoys network effects which helps fuel our continued growth.

As depicted in slide number six, we believe that as we continue to scale, we are able to deliver increasing value to both sellers and buyers which further strengthens our competitive position in the marketplace. We refer to this self-reinforcing growth dynamic as the LSI network effect.

Our growing buyer liquidity, value-added services and merchandising expertise are increasingly attractive to sellers versus alternative methods. As the breadth and volume of goods in our marketplace expands, professional buyers benefit from using our online marketplace as a one-stop shop to source goods to sustain a profit in their own business. This dynamic is evident in the acceleration and the growth of our commercial business.

As depicted in slide seven, GMV associated with our commercial businesses averaged 29% sequential quarterly growth over the past six quarters which represents total growth of approximately 261% over the last 18 months. During Q2, our commercial GMV grew by $8.5 million or 42% sequentially from Q1.

Our current modest penetration of existing commercial clients presents us a significant opportunity to continue to rapidly grow our commercial business. In line with the strong demand for our services, we have made numerous recent investments for future growth.

For example, during Q2, we hired a new general manager for our commercial asset recovery division, expanded our commercial sales and account management teams and opened a new leased office facility in Washington, D.C. to support our growth. We expect to realize significant operating leverage on these fixed investments in the next several quarters.

Our DoD scrap business also continues to grow at an attractive rate. As depicted in slide number eight, scrap GMV has averaged 14.5% sequential quarterly growth over the last six quarters which represents total growth of approximately 96% over the last 18 months.

In particular, we continue to benefit from improvements we are making in the sorting and merchandising of scrap metal categories that we bring to our online marketplace. A passion and focus of LSI is maximizing auction results for our sellers.

As depicted on slide number nine, our team continues to maintain a highly liquid and competitive buyer base for large lots of less than new merchandise. Our critical mass of professional buyers enables us to price reverse supply chain merchandise efficiently in 500 product categories. We leverage our growing transaction and buyer database to develop smart business rules to connect the right information with the right buyer audience for everything we sell to maximize buyer participation.

As depicted on slide nine, our internal goal is to attract at least three auction participants per transaction. We continue to exceed this target and have consistently averaged approximately five auction participants for every lot we sell. This compares to only one to two in consumer marketplaces.

The quality and depth of our unique buyer base drives high conversion rates in our marketplace. For example, 85% to 90% of everything we list sells in a cash transaction the first time. This compares to less than 50% in consumer auction marketplaces.

As you may imagine, there's a wide variety of goods that flow through our online marketplace. This is fueled by the fact that approximately 6% of everything that is sold in traditional retail outlets is returned and that number is twice as high in online retail.

Depicted in slide number 10 are just a few examples of the auctions we completed during Q2 in our liquidation.com marketplace. Our online marketplace offers sellers the ability to sell large lots of store returned and shelve pulled merchandise in a competitive and transparent manner. Our large and active buyer base provides sellers with true market pricing in product categories such as consumer electronics, general retail merchandise and apparel items such as you see here in this slide.

As depicted in slide 11, our govliquidation.com marketplace also continues to exhibit strong demand for offered products such as scrap metal, professional equipment and IT assets to deliver top pricing to our government clients such as the Department of Defense. Some of our scrap auctions regularly exceed over $1 million which is very exciting for our clients.

At this time, I will turn the presentation over to Jim Rallo, our Chief Financial Officer and Treasurer.

Thanks, Bill. As depicted on slide 13, the company continues to experience strong top line growth. The amount of gross merchandise volume or GMV transacted through our marketplaces increased $16.2 million or 36.9% to $60 million for the three months ended March 31, 2007 from $43.8 million for the three months ended March 31, 2006.

We believe this increase is attributable to our investment in our sales and marketing organization, the acquisition of STR on October 16, 2006, as well as increased marketing acceptance by corporate sellers and professional buyers of our online marketplaces as an efficient channel to auction and purchase wholesale surplus and salvage assets which resulted in 160.7% growth in our commercial marketplace over this same period last year.

In addition, our scrap contract, which generated 27.8% of our revenue and 22.9% of our gross merchandise volume for the three months ended March 31, 2007, grew 62% from the three months ended March 31, 2006. The growth of our commercial and scrap businesses is partially offset by a 33.3% decrease in our surplus business for the three months ended March 31, 2006 compared to the three months ended March 31, 2007.

Revenue increased $12.2 million or 32.8% to $49.3 million for the three months ended March 31, 2007 from $37.1 million for the three months ended March 31, 2006. This increase is probably due to the items driving GMV growth.

Costs of goods sold excluding amortization increased $9.1 million or 350.8% to $11.7 million for the three months ended March 31, 2007 from $2.6 million for the three months ended March 31, 2006. As a percentage of revenue, cost of goods sold excluding amortization increased to 23.7% for the three months ended March 31, 2007 from 7% for the three months ended March 31, 2006. This increase was primarily due to an increase in merchandise repurchase for our own account and the acquisition of STR.

Profit sharing distributions decreased $3 million or 14.4% to $17.7 million for the three months ended March 31, 2007 from $20.7 million for the three months ended March 31, 2006. As a percentage of revenue, profit sharing distributions decreased to 36% for the three months ended March 31, 2007 from 55.8% for the three months ended March 31, 2006.

This decrease is a result of faster growth in our commercial business where most of our sellers have adopted our consignment model as well as a decrease in the amount of profits we're required to pay the DoD under our surplus contract which was modified on September 12th, 2006.

Technology and operation expenses increased $3.7 million or 77.2% to $8.4 million for the three months ended March 31, 2007, from $4.7 million for the three months ended March 31, 2006. As a percentage of revenue these expenses increased to 17.1% for the three months ended March 31, 2007 from 12.8% for the three months ended March 31, 2006. This increase was probably due to the addition of 141 technology and operations personnel needed to support the increased volume of transactions in merchandise discussed above for our commercial businesses.

But we added four distribution centers over the last 12 months. The increase as a percentage of revenues is primarily the result of 45 of the 141 additional operating personnel which were needed to support our revenue is primarily the result of the inventory assurance program under the surplus contract in conjunction with the contract modification on September 12th, as well as a less than optimal utilization of our distribution center network where we have invested over the last 12 months to support continued growth in our commercial business.

Sales and marketing expenses increased $1.1 million or 53.6% to $3.2 million for the three months ended March 31, 2007, from $2.1 million for the three months ended March 31, 2006. As a percentage of revenue these expenses increased to 6.6% for the three months ended March 31, 2007 from 5.7% for the three months ended March 31, 2006. This increase is probably due to our hiring of 16 additional sales and marketing personnel and $400,000 in increased expenditures on marketing and promotional activities, the majority of which were needed to support the growth of our commercial business.

General and administrative expenses increased $800,000 or 27.5% to $4 million for the three months ended March 31, 2007 from $3.2 million for the three months ended March 31, 2006. The increase is probably due to one, cost of $100,000 related to an additional accounting legal assurance compliance and other expenses related to being a public company; expenses of $400,000 related to the adoption of statement 123R; and, three, costs of $200,000 for executive and administrative staff to support our growth and the requirements of being a public company.

As a percentage of revenue, these expenses decreased to 8.2% for the three months ended March 31, 2007 from 8.6% for the three months ended March 31, 2006 as a result of operating efficiencies gained from fixed-costs which is corporate staff which is spread over a larger revenue base.

As shown on slide 14, the Company continues to have strong cash flow. Adjusted earnings before interest, taxes, depreciation and amortization, or adjusted EBITDA, increased $900,000 or 23% to $4.7 million for the three months ended March 31, 2007, from $3.8 million for the three months ended March 31, 2006.

Slide 15 depicts the Company's continued achievement of better than 30% bottom line growth. Adjusted net income increased $800,000 to $2.8 million for the three months ended March 31, 2007, from $2 million for the three months ended March 31, 2006. As a percentage of revenue, adjusted net income increased to 5.6% for the three months ended March 31, 2007 from 5.3% for the three months ended March 31, 2006.

Adjusted diluted earnings per share increased $0.02 to $0.10 for the three months ended March 31, 2007 based on 28.5 million diluted weighted average shares outstanding from $0.08 and 25.1 million diluted weighted average shares outstanding for the three months ended March 31, 2006.

I'll now discuss the Company's other key operating metrics which are presented on slide 16. I've already touched on GMV which management believes allows us to monitor the success of our marketing programs as well as our [line] and merchandising strategies.

During the last 12 months we have also benefited from our ability to more effectively market assets to potential buyers as we gain transaction experience and industry knowledge in the vertical product segments auctioned through our marketplaces. Our marketing efforts resulted in approximately 33.5% increase in registered buyers to approximately 613,000 at March 31, 2007 from approximately 459,000 at March 31, 2006.

Auction participants, which consist of registered buyers who have bid in an auction during the period and are counted more than once if they bid in more than one auction, increased to a record 287,000 for the three months ended March 31, 2007, representing an increase of 26,000 or approximately 10% over the 261,000 auction participants for the three months ended March 31, 2006.

Completed transactions increased 9% to approximately 52,000 for the three months ended March 31, 2007 from approximately 48,000 for the three months ended March 31, 2006. In addition, the Company is seeing a significant increase in average transaction value to $1,144 for the three months ended March 31, 2007 from $912 for the three months ended March 31, 2006. This 25% increase is being driven by our buyers who are looking for larger merchandise lots, especially in our scrap business.

As shown on slide 17, the Company continues to have a strong balance sheet. On March 31, 2007, LSI had $60.2 million of cash, current assets of $80.1 million and total assets of $102.2 million. The Company continues to be debt free with current liabilities of $26.6 million and long-term liabilities of $1.5 million for total liabilities of $28.1 million at March 31, 2007. Stockholders' equity totaled $74.1 million at March 31, 2007.

The management team is providing the following guidance for the next quarter and fiscal year 2007. The following forward-looking statements are based on current business trends and our current operating environment including, one, the reengineering of certain business and inventory processes in our surplus business with the Department of Defense or DoD which has resulted in a slowdown of property received by the DoD and that we anticipate a modest increase in the flow of these goods over the next two quarters from the quarter ended March 31, 2007; two, the fact that we believe we have yet to realize the full potential of recent significant investments in new distribution centers, personnel and value added services necessary to support a much larger commercial business in the future which has resulted in a less than optimal profitability in the near them; and three, the acquisition of STR which closed on October 16, 2006.

Our results may be materially affected by changes in business trends in our operating environment as well as by other factors, including investments we expect to make in our infrastructure and value added services to support new business in both commercial and public sector markets.

Our scrap contract with the DoD includes an incentive feature which can increase the amount of profit sharing distribution we receive from 20% up to 22%. Payments under this incentive feature are based on the amount of scrap we sell for the DoD to small businesses during the preceding 12 months as of June 30th of each year. Therefore, we will record this benefit to the extent achieved for the 12 months ended June 30, 2007, in the quarter ended June 30, 2007.

We are eligible to receive this incentive in each year of the term of the scrap contracts. For the purposes of providing guidance regarding our projected financial results for fiscal year 2007, we have assumed that we will receive this incentive in the quarter ended June 30, 2007. In addition, there are incentive features in our surplus contract that allow us to earn up to an additional 5.5% of the profit sharing distribution above our new base rate of 25%, which began on December 1, 2006.

For the purposes of providing guidance regarding our projected financial results for fiscal year 2007, we have assumed that we will not receive any of the surplus contract incentive payments as the period we would be eligible to record such incentives may not occur until the fourth quarter of fiscal year 2007 or the first quarter of fiscal year 2008.

Our guidance adjusts EBITDA and diluted EPS for the effects of the adoption of FAS 123R, which we estimate to be approximately $525,000 to $575,000 for each of the remaining quarters in fiscal year 2007.

We expect GMV for fiscal year 2007 to range from $230 million to $235 million which is an increase from the $220 million to $225 million range provided the last quarter. We expect GMV for Q3 '07 to range from $58 million to $60 million.

We expect adjusted EBITDA for fiscal year 2007 to range from $19.5 million to $20.5 million, which is an increase from the $19 million to $20 million range provided the last quarter. We expect adjusted EBITDA for Q3 '07 to range from $5.6 million to $5.8 million.

We estimate adjusted earnings per diluted share for fiscal year 2007 to range from $0.41 to $0.42 which is an increase from the $0.40 to $0.42 provided last quarter. And in Q3'07, we estimate adjusted earnings per diluted share to be approximately $0.12.

I'll now turn our discussion back over to Bill.

We appreciate everyone's attention on this call. At this time, we'll open it up for questions.

(OPERATOR INSTRUCTIONS).

Your first question comes from the line of Paul Keung with CIBC World Markets. Please proceed.

This is [Mauris Musraker] calling for Paul. Good quarter. I was wondering if you could give us some more color on the strong growth in commercial. How much of that is coming from the large sellers, how much from STR's, and also if there were any new, large service accounts that you signed up in the March quarter?

This is Bill. First, as I indicated in my statement, the vast majority of our growth in this last many quarters has come from increased penetration of existing sellers, yet we do see quite a bit of demand for our service offering. We continue to expand the portfolio of relationships with Fortune 500 corporations which primarily take the form of big box retailers and department store chains.

I think another area of opportunity that we've done some initial spade work in is working with the manufacturers who supply these retailers who often have the responsibility to physically take back goods from retail store distribution center locations and it makes little sense for them to invest in the incremental touch or shipment of these items.

So with about 35 major Fortune 500 sellers in some phase of work with us, we have a very attractive portfolio of sellers. No single seller is driving the overall future of our business, so we see lots of upside. We're pleased with the progress we've made.

Thank you.

Next question comes from the line of Chris Penny with FBR. Please proceed.

Thank you. Good afternoon.

Bill, a question on the surplus. The decline kind of quarter-over-quarter, I assume that the DoD is not seeing a decline in the supply that they need to sell and you've talked about a modest increase in the next couple of quarters. What happens after that, or is there going to be a period where we should see a larger amount of volume pick up in a quarter?

Thanks for the question. Let me just make a few observations on the surplus kind of for DoD. I think our observations on the slowdown of goods received on this contract are at least three things that are in the control -- in the hands of the government and which we exert very little control over. One is delays in hiring and staffing open positions in the CPC hubs.

Those positions are defined. DoD is working to fill them which is taking longer. We see slower throughput of reviewing property by the government due to inexperience with these new procedures. Incrementally that's improving. And we've also seen, in certain situations where the DoD has closed or relocated warehouse facilities due to BRAC, an inability of generators to turn in and have processed in a timely manner surplus property. So we view all of these items as one-time in nature.

The DoD is going to solve these issues. We would expect improving trends over time. We have seen improving trends in our surplus business with the DoD during April. I would say our outlook for the second half of the year is expecting more modest increases incrementally. I think as Jim mentioned, we would expect sequential growth in DoD surplus in June over March quarter but modest growth.

Okay, two other questions. You don't have a full balance sheet on there. I was wondering, if I do my calculations right, it looks like working capital was about a drain of cash flow about $3 million or so in the quarter, bringing your cash flow to about -- your operational cash flow to about breakeven. That's kind of my calculations. Is that right or wrong and, if so, what is happening with the working capital? Secondly, what were your CapEx -- what was CapEx in the quarter?

Sure, I'll take those Chris. I guess a couple of things. One, your calculation is roughly correct. They'll be a full balance sheet provided within the next couple of days on our Q. Most of the increases had to do just around some accounts receivable which, in the past, we have not had a lot of. We do offer some receivables under our term contracts with the scrap business. That has gone up recently.

As well as some of the larger STR buyers historically, we've decided to offer a limited credit to a few of those folks. I would say it's a handful at this point and so you kind of went from hardly anything in A/R to a more significant balance, albeit compared to the business still relatively small. That is the primary reason, along with inventory, which is a little higher this quarter too.

This is technically property which we purchased for our own account either via historical STR relationships or through our own pilot programs here on the asset recovery side of the business so those programs have jumped up significantly in the last quarter and so you've seen an increase in inventory. So the real -- I'd say the cash flow from operations was affected significantly by that.

To answer your question on CapEx for the quarter, we had a total of $800,000 of CapEx for this quarter but to be clear, $400,000 was related to the build out of additional office space, at least here in D.C. which Bill mentioned in his comments.

Okay. And then the last question, just kind of a bigger picture question. Similar to the last two quarters you really beat the top line here well. You've invested a lot in the business kind of across the board. Is there a point where we start to see that excess fall down to the bottom line or do we just expect to see continued investment for the next year as you continue to build the company? When does that kind of upside start to follow the bottom line?

Well let me just comment on the current quarter and offer some thoughts for future reference. EBITDA as a percentage of GMV is something that we look at closely and, indeed, in the Q2 that ratio was flat versus the prior quarter due primarily to two factors. One, as you pointed out, we had relatively meaningful sequential decline in surplus GMV which we do expect to self-correct, so I think we were impaired in the Q2 versus sort of historical quarters on a margin basis.

I think, secondly, we are incurring higher G&A costs in our commercial business primarily due the addition of staff -- senior management staff, in most cases, and office space which we do expect to get leverage on very soon. And I think we're actually getting very good margin expansion on the investments we have made in operations and technology in the commercial business. Jim mentioned the number of facilities we've opened up over the last 12 months. We are starting to get good leverage on that but this is being masked by the other factors I mentioned.

Yes, Chris, as far as timing, I think that the commercial business growth is outpacing our own expectations, obviously, the last couple of quarters compared to guidance. And we're doing what we can to continue investment in those areas to continue to drive that growth, so as long as we're experiencing hypergrowth I think we're going to continue to make those expenses. I think once we get down to what I would say is more of a growth company type of profile, that's when we'll start to get leverage.

So it's safe to say that the commercial business has picked up faster than you expected but -- and you're just having to divest a little bit forward of that just a little bit faster because you didn't expect this pickup as quickly?

Absolutely. I think in one example, obviously, when you add a new general manager for a division, this is a significant one-time fixed cost to adjust. In that case -- and there's a separate press release that you may have seen on Tom Schmidt -- expect to build a pretty significant business then we'll get leverage on that for many years to come.

We also, obviously, are building our office space to support back office operations and a larger account management team to support these existing seller relationships. So in both instances, we will digest that now for many years of future growth.

Great. Thank you very much.

Your next question comes from the line of Stephen Jue with RBC Capital Markets. Please proceed.

Good afternoon, gentlemen. With the GMV guidance being flat to slightly down sequentially and with surplus looking to come up modestly, I guess the implication is for the commercial marketplaces and/or scrap to be down sequentially. What are you seeing in terms of trends? Is some seasonality at play here?

Sure, Stephen, I'll take that one. We're not really anticipating a down quarter in the commercial business at all, and I think we continue to see good year-over-year growth there. The surplus as we indicated, we would expect to see a modest increase but most of the decrease to the extent that we have it -- and, again, the range that we offered was $58 million to $60 million for the last quarter, so up at the high end of the range it would be flat, somewhere at the lower end slightly down -- is coming from the scrap business.

We once again had a phenomenal quarter above expectations in the scrap business, Stephen. I know you track that closely so you saw a lot of that come in at the end which was, again, outside of our sort of guidance vision in the last quarter as we didn't clearly know the timing of those events.

I would say that we have guided the scrap business as we have done for the last two quarters on what we anticipate is a normalized scrap level which still, for the most case, anticipates growth. But again, we don't expect the sort of 13.5 million plus quarters to happen often.

Understood. How much of your STR GMV are you running through your liquidation.com platform right now?

In the last quarter, we didn't run any of our STR GMV through the liquidation.com platform. You'll start to see an integration of that during this quarter.

Okay. How will we know?

Well I don't think that you're going to specifically be able to identify specific lots, Stephen. I mean, it's not going to be identified as STR inventory. I mean, STR has been integrated into our operations. The California warehouse distribution centers are now integrated into our systems and so it's really just another site for goods to be shipped to our buyers.

I think what you might see is an increase in truckload sales. STR historically had done more truckload sales than our own commercial division had done in the past, so to the extent you see those growing out that would be a little bit of a hint there.

Okay. Thank you.

Your next question comes from the line of Shawn Milne with Oppenheimer. Please proceed.

Thank you and good afternoon. I want to come back to the questions on expenses in the quarter. It seems like, Billy, loud and clear that there's been some one-time investments you talked about on the G&A line which you should get leverage on going forward, but maybe you can outline a little bit more on the technology side.

Is this a step-up function in the quarter where the new run rate is around 8.4 million, or should we continue to expect this to grow at this kind of rate going forward?

And then the other question I have is what is -- if you can give us the sense of your current capacity in your distribution centers for the commercial business. You've suggested it was less than optimal utilization in the quarter. How much excess capacity do you have?

And then lastly, you talked about -- there's a question about STR. You know, obviously, the purchase -- the purchase GMV was higher than what we were looking for. Was that upside from more STR or a higher number of pilot programs on the commercial side? Thank you.

Sure. I would first comment on the technology ops question. Clearly, we have a step function at work here because the success of a distribution network largely resides with the quality of the management team running those distribution center hubs, and in many instances -- Indianapolis is a great example.

We went out and were very disciplined and identified and hired a very high quality manager, and that investment is made and is going to support not only a more efficient warehouse hub but knowledge sharing across our entire network of hubs. So we are biting off those investments now. It's the right way to lead the business ahead of good demand for our services and so that step function has taken place.

Second, on the capacity of the distribution center hubs, I would say conservatively two to three times additional volume can flow through -- more than today can flow through the distribution center hubs and there are other ways to get leverage above that. And so with most of these then having been implemented in the last 12 months, there's still a newness of process and people to the LSI organization that really aren't assumed in that capacity increase and so the learning curve is leveraged. You would see capacity above a two to three times increase in volume through those networks.

And I would say, third, with our commercial pipeline, we've also seen interest in having LSI co-locate within commercial seller distribution center facilities which doesn't constrain us in any way to our own lease distribution center hubs.

So I think there's a broader theme, Shawn, where you sit down with a major corporation, they want to have a process map, not where your process ends and their process begins but going across the organizations and facilities and IT and that's how we want to think. So there will be situations, I believe, where we'll actually have our people in our client's facilities because it makes sense either fewer costs to handle and touch goods, optimal warehousing costs et cetera.

As far as the purchase transactions, STR versus other. As I've said before -- as Jim said before, we are frankly indifferent between conducting profit sharing/principal risk business versus consignment business. Our overall focus is GMV and EBITDA, and with over 750,000 completed auction transactions, we are the marketplace for these goods.

So in a principal risk transaction we're able to establish the appropriate amount of the upfront payment to make to a seller who wishes, for accounting or other reasons, to begin a relationship or sustain a relationship in a principal transaction. So we're able to realize, because we've set those prices, the same contribution margins as a percentage of GMV as we would under our consignment model.

We have seen many of those sellers evolve to a consignment model over time. I would say, in many cases, these larger companies either driven by financial controls or SOX policies or inertia want to start the relationship in a upfront either purchase or purchase with outside profit sharing relationship so this is not limited to STR.

We've seen this in many instances outside STR and we've also approached some folks that are doing business with the acquired STR business on a principal risk basis and discussing migration to consignment or profit sharing. So it is one business. I mean, the STR versus LSI will sort of melt away as we integrate the company.

Shawn to be clear, though, the STR integration is going well and that business is running ahead of our expectations so we originally guided to $18 million of top line this year. We said the last quarter that that was ahead of expectations. It still continues to run ahead of expectations this quarter so both -- if you look at it that way, that side of the business as well as the commercial business, which we have historically had, is running a little bit ahead on the purchase transactions.

Thank you.

Your next question comes from the line of Stephen Jue with RBC Capital Markets. Please proceed.

Hi. I think there was a question about CapEx during the quarter. I'm sorry if I missed it. And will you update us on your CapEx outlook for the balance of the year?

Absolutely, Stephen. Yes, CapEx for the quarter was about $800,000. $400,000 of that was actually related to an office built out here in Washington, D.C. to expand the administrative and support staff that includes our sales and marketing folks based here, and as well as some of our technology folks based here.

From an accounting standpoint, actually that cash -- a lot of that cash was reimbursed through tenant improvements but from the way you account for that that, tenant improvement gets amortized over the term of the lease. So even though we had $400,000 in CapEx related to that office space we really didn't have the cash out the door.

Our CapEx guidance then, assuming you look at it that our total CapEx this quarter was $800,000, we had about $800,000 the last quarter. Most of that was operational in nature. We're looking at about $2 million to $2.5 million for the full year which is about $500,000 higher than we thought going in.

Okay. And Bill, I think you mentioned BRAC briefly. Is there any change there from what you guys have been seeing?

Nothing that's meaningful that we would view affecting our guidance at this point. And I think, again, I mean we've tried to be very transparent with our owners. If we think that surplus GMV is changing, we will revise it accordingly.

Thank you.

Your next question comes from the line of Colin Sebastian with Lazard Capital Markets. Please proceed.

Good afternoon, and thanks for taking my questions. I just have a couple left.

I think you've touched on this already but can you just talk again about the visibility you have on achieving the higher profit sharing amounts on the inventory assurance part of the surplus contracts? And then secondly, I was curious if you could break out on the commercial side for the quarter the organic growth of existing sellers versus incremental additions? Thank you.

Let me comment on the inventory assurance work. As a general matter, we think we're pretty good at developing software and processes around this reverse supply chain business, and from our perspective, we're following through on everything that we had identified in this additional scope of work with the client. But, ultimately, we're not self-evaluating our work and so we can't give you something tangible that would be definitive on the level of performance or earn out of incentive.

But from a management's point of view, I think Ben Brown and his entire team have done a terrific job in the rollout of inventory assurance services and we feel good about the work we've done.

Colin, on the break out of organic growth, we're not really splitting the businesses. I mean it's going to be getting actually more blended as we move forward. What I can tell you is that the commercial business originally operated by just LSI's standalone was significantly over 100% growth again this quarter so this has been our sixth quarter of over 100% organic growth.

Okay, thank you. And just lastly, as you've added more large partners onto the commercial platform, as you said in the prepared remarks, can you talk about some of the trends you're seeing with those rates there with those partners and how you view that as impacting the overall platform? Thank you.

Well we think that we have an ideal avenue for creating upside as far as sellers and we do experiment with different lot sizes from -- you take examples of high value consumer electronics like iPods. You might see them in smaller lots, 20, 30, 40 at a time. There were some examples in the slide deck for this call where you saw some high value consumer electronics in lot sizes of 14 but you're commanding $2,700 for that lot.

In other instances we're doing truckloads, truckloads of hard goods that are priced 3,000, 4,000, 5,000, 6,000 per transaction so there's a spectrum that I think -- we're a very data driven company and we are always adapting our merchandising decisions which is what is the appropriate lot size, what's the appropriate level of detail in terms of manifest at the item level or at a more macro level.

And also on the shipping side, all of these items are very transparent to the buyer what it costs to ship the item from the seller location to the buyer location. And so we're constantly screening and evaluating that data to derive the optimal sale for the seller. And when I say optimal, that means high conversion rate at a very high rate of return or sales valuation realization for the seller.

And we are consistently in our business and it's a business where you have new in the box to salvage and an 85 to 90% conversion on the initial listing on our auction marketplace. And I think that's impressive because this is not new merchandise. It's less than new, open box return items and buyers who come to the marketplace -- you know our business buyers and they're able to leverage this information, make informed purchases and come back to do more business with us so we feel that we have a great track record of serving these large sellers with this merchandise.

Okay. Congratulations on the quarter.

Thank you.

Your next question comes from the line of Derek Brown of Cantor Fitzgerald. Please proceed.

Thank you. Two questions, the first on the commercial side of the business. Of the clients that you are currently serving, could you give a rough approximation for how penetrated you are, you think, with the amount of supply that they theoretically could bring to the table?

The other question and, again, relates to the commercial side of the business, but are you seeing any changes on the competitive landscape as you go in and talk to prospective accounts or, again, trying to penetrate further on existing accounts? Are there new people coming to the table or are there new economics being put in front of folks?

Well first on the addressable market opportunity -- and then I'll get to the penetration question. There are about 300 companies that retail or supply finished goods that we are targeting as we rollout our marketplace, and that equates to $5 billion to $10 billion of GMV, GMV that would be comparable to the transaction value in our marketplace. So very attractive for us and we see a lot of commonalties in product condition, logistics issues that we can address quite well.

Among the 30 to 35 commercial clients who we're working with, clearly over -- well over a billion dollars of addressable GMV opportunity, 10% to 15% penetration is about where we are. That can be a little higher with someone we're working with for over a year or two.

So we think we're scratching the potential surface of the opportunity and in these relationships still finding lots of ways to integrate, lots of ways to get process automation, better access to information, save our clients costs by co-locating at their facilities or leveraging back haul trucks -- a lot of different ideas, clever ideas to integrate with us and we are always positioning ourselves against the traditional liquidator.

I mean there is a quite large network, fragmented network, of people that will offer cash in a local environment at the store level, at the distribution center level to buy these goods and take them away. And so, in a large corporation, if it's very decentralized that might rule the day. But I think we're a company and we have a platform to make the business case to not have it on a decentralized basis to centralize it, to manage it and to benchmark it and improve the results and so that's what we're displacing.

We're disintermediating this patchwork of local buyers who are welcome to come and bid on the merchandise and directed, in many cases, to come to liquidation.com to bid on the merchandise. But that is our primary competition, Derek. And for the reasons that we talked about in our value proposition, we align our interests with the sellers. We're not trying to be adversarial and purchase something and keep the upside for ourselves. We share data with our sellers, very unusual in this marketplace. We are an open book on what we sell the goods for, the timing of the auctions.

Sellers have access to go back in to do a (inaudible) and follow all of this on their own and we're an intense service. So we've observed these sellers, they don't want merely a place to list goods and handle the transaction on their own. They do want an end-to-end solution and the creditability to handle their needs across the country and so we see lots of opportunity to leverage those differentiators in the commercial marketplace.

That's very helpful. Thank you.

The next question comes from the line of Scott Devitt with Stifel Nicolaus. Please proceed.

Thanks. Two questions. The first one's on STR. I believe when you did the deal you mentioned the capacity to deepen the existing relationships with partners by offering a nationwide network of regional fulfillment centers and STR was specifically focused on providing services, I believe, within the California supply channel. Can you just update us on progress there in terms of deepening the relationships and working in other regions with existing partners?

Scott, it's Bill and I think that's a great comment -- great question. Indeed, I can think of a handful of meetings since the beginning of the year with those historical relationships where we have been able to broaden geographically, broaden by product category and SKU those relationships.

And it's exactly what we base sort of the underwriting of that transaction on in terms of our ability to cross-pollinate sellers with our services and our buyers and vice versa, and so I think it's just an interesting market where you can get leverage through acquisition if you have a model where you can assimilate all that information and connect sellers with your marketplace efficiently, which we have, so that's been a very attractive part of that acquisition.

And then the second question is just more housekeeping related. Jim, I was wondering if you could give us the stock comp actually by line item just so that we can back into the cash earnings without just backing out of one line, so the 519 how that looked per operating expense line item.

Well, most of that is running through the G&A line, Scott, so there's very little of the 519. There's less than 100,000 that's running through either tech and ops or sales and marketing.

Okay. Can you give the exact number that's in G&A?

I don't have that information with me.

Okay. Will it be in the Q?

No. We haven't been breaking it out by specific line item...

Okay.

... historically, primarily because it just hasn't been material at that level, Scott.

Okay. It's, I suppose, helpful in terms of understanding growth rates of operating expenses given the volatility and the stock comp, but that's okay. I can take it offline. I appreciate the comments. Thank you.

Your next question comes from the line of Steve Weinstein with Pacific Crest. Please proceed.

Great. Thank you very much. I just had a few more questions on the transactions where you were acting as the principal. I don't put words in your mouth but are you indicating that you think that there's some structural change where you'd expect to do business in that way on an ongoing basis with some clients, or is the goal always going to be still to try and move them to one of the two original models?

Let me, Steve, first address sort of the philosophy and approach of the business. We've always taken the philosophy and approach that the best pricing model for our sellers is ultimately consignment or a de-profit share relationship. Ultimately, the seller has to embrace that.

And the answer is sellers who monitor recovery value are going to move to that, and a principal risk arrangement is sometimes the most expedient way to kick-start a relationship but we share all that data back and clients can, on a cumulative basis, track what they give up is by not having taken a consignment type of arrangement. And so we would always point to an alignment of the pricing model around consignment or principal risk.

But we're going out there and talking to major companies and, in some cases, the company is not going to change its accounting regime in the early stages of the relationship with the service provider, and so instead of trying to turn the aircraft carrier to consignment model right out of the gates of a relationship, we'd just as soon start to accumulate data that provides their own business case to move to a consignment model.

Okay. If you backed STR out of that component of the business, how many clients are you talking about now that are you're currently buying inventory off of?

I don't have a number that comes to mind, but I would say that number can vary and it would probably be a handful.

Okay, great. Thank you.

(OPERATOR INSTRUCTIONS)

Your next question is a follow-up question from the line of Chris Penny with FBR. Please proceed.

Quick question on that 5.5% incentive fee. You plan that will be recognized, or a percentage of that will be recognized, either in the fourth or the first quarter and that will be a function of the total volume for the fiscal year and the surplus. Is that correct?

The measurement period, Chris, would be from December 1, officially, of 2006 through September 30th, so it would be a 10-month measurement period per the modified contract.

Okay. And then just to be clear then, forward years I would assume would then start October 1st to September 30th for the measurement period?

That's correct.

And will it always be a one-time 5.5%?

That's correct. It will be treated exactly like the scrap surplus incentive.

Okay, perfect. Thanks.

From an accounting standpoint.

Thanks.

It appears we have no more questions in queue. I'd like to turn the conference back over to management for closing remarks.

Thanks, everyone, for your participation in our Q2 fiscal year 2007 call, and we look forward to maintaining contact with you in the future. If you have any additional questions, please do not hesitate to contact Jim Rallo, myself or Julie Davis. Thank you.

Thank you for your participation in today's conference. This concludes our presentation. You may now disconnect. Have a good day.