GSI COMMERCE INC - 10-Q Quarterly Report

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No ¨

Indicate by check mark whether the registrant is an accelerated filer (as defined in Exchange Act Rule 12b-2). Yes x No ¨

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of August 2, 2004:

For all years prior to 1999, our fiscal year ended on December 31. Effective for 1999, we changed our fiscal year from the last day of December to the Saturday nearest the last day of December. Accordingly, references to fiscal 1999, fiscal 2000, fiscal 2001, fiscal 2002, fiscal 2003 and fiscal 2004 refer to the years ended January 1, 2000, December 30, 2000, December 29, 2001, December 28, 2002, January 3, 2004 and the year ending January 1, 2005.

Although we refer to the retailers, branded manufacturers, entertainment companies and professional sports organizations for which we develop and operate e-commerce businesses as our “partners,” we do not act as an agent or legal representative for any of our partners. We do not have the power or authority to legally bind any of our partners. Similarly, our partners do not have the power or authority to legally bind us. In addition, we do not have the types of liabilities for our partners that a general partner of a partnership would have.

Certain financial information is presented on a rounded basis, which may cause minor differences.

The accompanying notes are an integral part of these condensed consolidated financial statements.

GSI Commerce, Inc. (“GSI” or the “Company”), a Delaware corporation, provides an e-commerce platform that enables retailers, branded manufacturers, entertainment companies and professional sports organizations to operate e-commerce businesses. The Company’s e-commerce platform includes Web site design and development, e-commerce technology, managed hosting, order fulfillment, customer service, merchandising and order management, online merchandising, customer relationship management, content development and online marketing. The Company currently derives virtually all of its revenues from the sale of goods through its partners’ e-commerce businesses, toll-free telephone number sales, business-to-business and group sales and related outbound shipping charges, net of allowances for returns and discounts. The Company also derives revenue from fixed and variable fees earned in connection with the development and operation of partners’ e-commerce businesses and the provision of marketing and other services.

The accompanying condensed consolidated financial statements of the Company have been prepared in accordance with accounting principles generally accepted in the United States of America for interim financial information and in accordance with the instructions for Form 10-Q and Rule 10-01 of Regulation S-X. Accordingly, they do not include all information and footnotes required by accounting principles generally accepted in the United States of America for complete financial statements.

The accompanying financial information is unaudited; however, in the opinion of the Company’s management, all adjustments (consisting of normal recurring adjustments and accruals) necessary to present fairly the financial position, results of operations and cash flows for the periods reported have been included. The results of operations for the periods reported are not necessarily indicative of those that may be expected for a full year.

This quarterly report should be read in conjunction with the financial statements and notes thereto included in the Company’s audited financial statements presented in the Company’s Annual Report on Form 10-K filed with the Securities and Exchange Commission on March 18, 2004, as amended May 3, 2004.

Certain reclassifications have been made to the prior year condensed consolidated financial statements to conform to those used in the current period.

Marketable Securities: Marketable securities, which consist of investments in debt securities, are classified as available-for-sale and are reported at fair value, with unrealized gains and losses recorded as a component of stockholders’ equity. The Company does not intend to hold its marketable securities for more than one year from the most recent balance sheet date and has therefore classified them as a current asset. Realized gains or losses and declines in value judged to be other than temporary, if any, on available-for-sale securities are reported in other income or loss. As of January 3, 2004, the aggregate amortized cost of the Company’s marketable securities approximated their aggregate fair value. As of July 3, 2004, the Company recorded net unrealized losses on its marketable securities of $97,000.

Notes Receivable and Other Equity Investments: On April 28, 2004, the Company converted $730,000 of principal due from Odimo Incorporated (“Odimo”) under a five year subordinated secured promissory note in exchange for 2,036,830 shares of Odimo’s Series C preferred stock and a warrant to purchase 305,525 shares of Odimo’s Series C preferred stock at an exercise price of $0.3584 per share. As a result of the conversion, the principal amount owing under the promissory note as of April 28, 2004 was $2.6 million, due in eleven consecutive quarterly payments of $225,000 each, beginning June 2004 through December 2006 and one final payment of $170,000 due in March 2007. The carrying amount of the portion of the note exchanged was approximately $682,000. In order to determine the fair value of the portion of the note exchanged, the Company obtained an independent, third-party valuation. Using this valuation, the Company determined the estimated fair value of the portion of the note exchanged to be approximately $688,000. The Company recorded the investment in Odimo at $688,000 and recorded a gain on the exchange of approximately $6,000 which is included in interest income.

During the three-month period ended July 3, 2004, the Company collected all amounts due under a $376,000 full-recourse promissory note, including accrued interest.

Other Assets, Net: Other assets, net consists primarily of deferred partner revenue share charges, resulting from the exercise of a right to receive 1,600,000 shares of the Company’s common stock in lieu of future cash partner revenue share payments. The 1,600,000 fully vested shares of the Company’s common stock issued are subject to restrictions on the holder’s ability to transfer such shares. These transfer restrictions lapsed as to 70% of such shares as of June 30, 2004 and will lapse as to 10% of such shares on the last day of each quarter thereafter, becoming free of all such transfer restrictions on March 31, 2005. Deferred partner revenue share charges were $11.8 million and $11.1 million as of January 3, 2004 and July 3, 2004, respectively, and are being amortized as stock-based compensation expense as the partner revenue share expense is incurred. The partner revenue share expense incurred is based on actual revenues recognized in a given period and the imputed partner revenue share percentage, which is based on the value of the Company’s common stock that was issued upon exercise of the right. Stock-based compensation expense related to the amortization of deferred partner revenue share charges was $273,000 and $495,000 for the three- and six-month periods ended June 28, 2003, respectively, and $332,000 and $692,000 for the three- and six-month periods ended July 3, 2004, respectively.

Shipping and Handling Costs: The Company defines shipping and handling costs as only those costs incurred for a third-party shipper to transport products to the customer and these costs are included in cost of revenues from product sales. In some instances, shipping and handling costs exceed shipping charges to the customer and are subsidized by the Company. Additionally, the Company selectively offers promotional free shipping whereby it ships merchandise to customers free of all shipping and handling charges. The cost of promotional free shipping and subsidized shipping and handling was $(105,000) and $401,000 for the three- and six-month periods ended June 28, 2003, respectively, and $473,000 and $1.1 million for the three- and six-month periods ended July 3, 2004, respectively, and was charged to sales and marketing expense.

Fulfillment Costs: The Company defines fulfillment costs as personnel, occupancy and other costs associated with its Kentucky fulfillment center and Ashford.com’s Texas fulfillment center that it formerly maintained, personnel and other costs associated with its logistical support and vendor operations departments and third-party warehouse and fulfillment services costs. Fulfillment costs were $2.7 million and $5.8 million for the three- and six-month periods ended June 28, 2003, respectively, and $4.7 million and $9.6 million for the three- and six-month periods ended July 3, 2004, respectively, and are included in sales and marketing expense.

Stock-Based Compensation: Statement of Financial Accounting Standards (“SFAS”) No. 123, “Accounting for Stock-Based Compensation,” encourages, but does not require, companies to record compensation cost for stock-based employee compensation plans at fair value. The Company has chosen to continue to account for stock-based compensation using the intrinsic method prescribed in Accounting Principles Board (“APB”) Opinion No. 25, “Accounting for Stock Issued to Employees,” and related interpretations. Accordingly, compensation expense for stock options issued to employees is measured as the excess, if any, of the quoted market price of the Company’s stock at the date of the grant over the amount an employee must pay to acquire the stock. The Company accounts for stock-based compensation for stock options and warrants issued to non-employees in accordance with SFAS No. 123 and Emerging Issues Task Force (“EITF”) No. 96-18, “Accounting for Equity Instruments That Are Issued to Other Than Employees for Acquiring, or in Conjunction with Selling, Goods or Services,” and EITF No. 00-18, “Accounting Recognition for Certain Transactions involving Equity Instruments Granted to Other Than Employees.” Accordingly, compensation expense for stock options and warrants issued to non-employees is measured using a Black-Scholes multiple option pricing model that takes into account significant assumptions as to the expected life of the option or warrant, the expected volatility of the Company’s common stock and the risk-free interest rate over the expected life of the option or warrant.

The following table illustrates the pro forma net loss and losses per share for the three- and six-month periods ended June 28, 2003 and July 3, 2004 as if compensation expense for stock options issued to employees had been determined consistent with SFAS No. 123:

The Company also records stock-based compensation as deferred partner revenue share charges are amortized. Stock-based compensation expense related to the amortization of deferred partner revenue share charges was $273,000 and $495,000 for the three- and six-month periods ended June 28, 2003, respectively, and $332,000 and $692,000 for the three- and six-month periods ended July 3, 2004, respectively.

In December 2002, the Company announced and implemented its plan to cease the operations of Ashford.com, which accounted for approximately $167,000 and $902,000 of the Company’s net revenues for the three- and six-month periods ended June 28, 2003, respectively, and $1,000 and $9,000 for the three- and six-month periods ended July 3, 2004, respectively. This plan involved the liquidation of Ashford.com’s remaining inventory, the closure of its Houston, Texas fulfillment center and offices and the termination of 71 employees. This plan was substantially completed in January 2003. As of July 3, 2004, 71 employees had been terminated and actual termination benefits paid were $417,000.

At July 3, 2004, the accrued liability associated with the cessation of Ashford.com operations was $370,000 and consisted of the following (in thousands):

The contractual obligations relate to agreements entered into by Ashford.com prior to the sale of assets to Odimo Acquisition Corp.

The amortized cost and estimated fair value of investments in debt securities as of July 3, 2004, by contractual maturity, are as follows:

On March 16, 2004, a wholly-owned subsidiary of the Company entered into an agreement to purchase a new corporate headquarters in King of Prussia, Pennsylvania, together with an option to purchase an additional parcel of land. The Company closed on the purchase on June 9, 2004 and the purchase price for the building was $17.0 million.

In connection with the purchase of the new corporate headquarters, a wholly-owned subsidiary of the Company entered into a $13.0 million mortgage note on June 9, 2004, collateralized by a first lien on substantially all of the assets of that subsidiary, which have a carrying value of approximately $17.5 million. The mortgage note has a term of ten years and six months and bears interest at 6.32% per annum. As of July 3, 2004, the mortgage note had an aggregate outstanding principal balance of $13.0 million, with $150,000 classified as current and $12.9 million classified as long term. The Company recorded $54,000 of interest expense related to the note during the three- and six-month periods ended July 3, 2004, respectively.

The fair value of the mortgage note is estimated based on current rates offered for similar debt with similar terms and maturity using available market information. As of July 3, 2004, the estimated fair value of the Company’s mortgage note approximates its carrying value.

Annual maturities of the mortgage note are based on a thirty-year amortization and as of July 3, 2004 are as follows (in thousands):

The following table summarizes the changes in stockholders’ equity for the three-month periods ended June 28, 2003 and July 3, 2004:

The Company maintains incentive and non-incentive stock option plans for certain employees, directors and other persons (the “Plans”). Under the terms of the Plans, the Company may grant incentive and non-incentive options and restricted stock and unrestricted stock awards to purchase up to 9,025,071 shares of common stock. The options granted under the Plans generally vest at various times over periods ranging up to five years and have terms of up to ten years after the date of grant, unless the optionee leaves the employ of or ceases to provide services to the Company. Stock appreciation rights (“SARs”) may be granted under the Plans either alone or in tandem with stock options. Generally, recipients of SARs are entitled to receive, upon exercise, cash or shares of common stock (valued at the then fair market value of the Company’s common stock) equal to such fair market value on the date of exercise minus such fair market value on the date of grant of the shares subject to the SAR, although certain other measurements also may be used. A SAR granted in tandem with a stock option is exercisable only if and to the extent that the option is exercised. No SARs have been granted to date under the Plans.

The following table summarizes the stock option activity for the three-month periods ended June 28, 2003 and July 3, 2004:

The following table summarizes the warrant activity for the three-month periods ended June 28, 2003 and July 3, 2004:

During the three-month period ended July 3, 2004, the Company granted to employees options to purchase an aggregate of 384,750 shares of the Company’s common stock at prices ranging from $8.51 to $10.89 per share. The weighted average fair value and the weighted average exercise price of the options granted with exercise prices at the then-current market prices of the underlying stock during the three-month period ended July 3, 2004 was $5.88 and $9.40 per share, respectively. For the three- and six-month periods ended July 3, 2004, the Company recorded $268,000 and $1,000 reductions in stock-based compensation expense, respectively, relating to options and restricted stock.

During the three-month period ended July 3, 2004, the Company granted to Rustic Canyon Ventures, LP (“Rustic Canyon”) a warrant to purchase 12,500 shares of the Company’s common stock at a price of $9.31 per share. The weighted average fair value and the weighted average exercise price of the warrant granted with an exercise price at the then-current market price of the underlying stock during the three-month period ended July 3, 2004 was $7.09 and $9.31 per share, respectively. For the three- and six-month periods ended July 3, 2004, the Company recorded $89,000 of stock-based compensation expense, respectively, relating to warrants.

During the three-month period ended June 28, 2003, the Company granted to employees options to purchase an aggregate of 32,800 shares of the Company’s common stock at a price of $2.34 per share. The weighted average fair value and the weighted average exercise price of the options granted with exercise prices at the then-current market prices of the underlying stock during the three-month period ended June 28, 2003 was $1.64 and $2.34 per share, respectively. For the three- and six-month periods ended June 28, 2003, the Company recorded $131,000 and $197,000 of stock-based compensation expense, respectively, relating to options and restricted stock.

The following table summarizes information regarding options and warrants outstanding and exercisable as of July 3, 2004:

As of July 3, 2004, 561,938 shares of common stock were available for future grants under the Plans.

The fair value of options granted under the Plans during the three-month periods ended June 28, 2003 and July 3, 2004 were estimated on the date of grant using the Black-Scholes multiple option pricing model, with the following weighted average assumptions:

No warrants were granted or issued by the Company during the three-month period ended June 28, 2003. The fair value of the warrant granted and issued during the three-month period ended July 3, 2004 was estimated on the date of grant using the Black-Scholes multiple pricing model, with the following assumptions:

Losses per share for all periods have been computed in accordance with SFAS No. 128, “Earnings Per Share.” Basic and diluted losses per share are computed by dividing net loss by the weighted average number of shares of common stock outstanding during the period. Outstanding common stock options and warrants have been excluded from the calculation of diluted losses per share because their effect would be antidilutive.

As of January 3, 2004 and July 3, 2004, the Company had $3.4 million and $7.5 million, respectively, of operating cash and $66.1 million and $40.7 million, respectively, of cash equivalents and marketable securities invested with several financial institutions, which are potentially subject to credit risk. The composition of these investments are regularly monitored by management of the Company.

During the three-month period ended July 3, 2004, the Company purchased inventory from one supplier amounting to $12.8 million or 37% of total inventory purchased. During the six-month period ended July 3, 2004, the Company purchased inventory from one supplier amounting to $25.3 million or 37% of total inventory purchased.

During the three-month period ended June 28, 2003, the Company purchased inventory from one supplier amounting to $8.9 million or 36% of total inventory purchased. During the six-month period ended June 28, 2003, the Company purchased inventory from one supplier amounting to $20.7 million or 38% of total inventory purchased.

No other supplier amounted to more than 10% of total inventory purchased for any period presented.

The Company is involved in various litigation incidental to its current and discontinued businesses, including alleged infringement of intellectual property rights of third parties, contractual claims and claims relating to the manner in which goods are sold through its e-commerce platform.

While the Company sold certain assets of Ashford.com, Inc. in December 2002, Ashford.com continues to be a party to certain litigation that was commenced prior to the Company’s acquisition of Ashford.com in March 2002. Since July 11, 2001, several stockholder class action complaints have been filed in the United States District Court of the Southern District of New York against Ashford.com, several of Ashford.com’s officers and directors, and various underwriters of Ashford.com’s initial public offering. The purported class actions have all been brought on behalf of purchasers of Ashford.com common stock during various periods beginning on September 22, 1999, the date of Ashford.com’s initial public offering. The plaintiffs allege that Ashford.com’s prospectus, included in Ashford.com’s Registration Statement on Form S-1 filed with the Securities and Exchange Commission, was materially false and misleading because it failed to disclose, among other things, certain fees and commissions collected by the underwriters or arrangements designed to inflate the price of the common stock. The plaintiffs further allege that because of these purchases, Ashford.com’s post-initial public offering stock price was artificially inflated. As a result of the alleged omissions in the prospectus and the purported inflation of the stock price, the plaintiffs claim violations of Sections 11 and 15 of the Securities Act of 1933 and Section 10(b) of the Securities Exchange Act of 1934. The complaints have been consolidated into a single action, and the consolidated cases against Ashford.com have been consolidated with similarly consolidated cases filed against 308 other issuer defendants for the purposes of pretrial proceedings. The claims against Ashford.com’s officers and directors were dismissed in exchange for tolling agreements which permit the refiling of claims

against officers and directors at a later date. A motion to dismiss filed on behalf of all issuer defendants, including Ashford.com, was denied in all aspects relevant to Ashford.com on February 19, 2003. Ashford.com and its insurers have entered into a memorandum of understanding regarding terms for settlement of this suit. Under the settlement, plaintiffs’ claims against Ashford.com and other issuers will be dismissed in exchange for certain consideration from the issuers’ insurers and for the issuers’ assignment to plaintiffs of certain potential claims against the underwriters of the relevant initial public offerings. Formal documentation of the settlement contemplated by the memorandum of understanding is complete and is pending approval by the judge presiding over this matter. In the event that a settlement is not finalized, the Company believes that Ashford.com has defenses against these actions.

In September 2003, the Company learned that it, along with several of its partners, were named in an action in the Circuit Court of Cook County, Illinois, by a private litigant who is alleging that the Company, along with certain of its partners, wrongfully failed to collect and remit sales and use taxes for sales of personal property to customers in Illinois and knowingly created records and statements falsely stating the Company was not required to collect or remit such taxes. The complaint seeks injunctive relief, unpaid taxes, interest, attorneys’ fees, civil penalties of up to $10,000 per violation, and treble damages under the Illinois Whistleblower Reward and Protection Act. The Company is aware that this same private litigant has filed similar actions against retailers in other states, and it may be possible that the Company and/or partners may have been or may be named in similar cases in other states. The Company does not believe that it is liable under existing laws and regulations for any failure to collect sales or other taxes relating to internet sales and intends to vigorously defend itself in this matter.

The Company does not believe, based on current knowledge, that any of the foregoing claims are likely to have a material adverse effect on its business, financial position or results of operations. However, the Company may incur substantial expenses and devote substantial time to defend third-party claims whether or not such claims are meritorious. In the event of a determination adverse to the Company, the Company may incur substantial monetary liability, and may be required to implement expensive changes in its business practices or enter into costly royalty or licensing agreements. Any of these could have a material adverse effect on the Company’s business, financial position or results of operations.

As of July 3, 2004, the Company had employment agreements with several of its employees for an aggregate annual base salary of $1.6 million plus bonuses and increases in accordance with the terms of the agreements. Remaining terms of such contracts range from less than one to three years.

As of July 3, 2004, the Company was contractually committed for the purchase of future advertising totaling approximately $206,000 through the fiscal year ending January 1, 2005. The expense related to these commitments will be recognized in accordance with the Company’s accounting policy related to advertising.

As of July 3, 2004, the Company was contractually committed to minimum cash revenue share payments of $375,000 per fiscal quarter through July, 2011.

The Company has entered into a strategic alliance to provide technology, procurement and fulfillment services for QVC, Inc. Interactive Technology Holdings, LLC, which is a major stockholder of the Company, is a joint venture company of Comcast Corporation and QVC. The Company recognized net revenues of $460,000 and $986,000 on sales to this related party for the three- and six-month periods ended June 28, 2003, respectively, and $238,000 and $571,000 for the three- and six-month periods ended July 3, 2004, respectively. The terms of these sales are comparable to those with other business-to-business partners of the Company. As of July 3, 2004, the amount included in accounts receivable was $333,000 related to these sales.

In the fiscal year ended January 3, 2004, the Company entered into an agreement with QVC pursuant to which QVC will provide shipping services to the Company in exchange for variable fees. The Company incurred fees of $0 for the three- and six-month periods ended June 28, 2003, respectively. The Company incurred fees of $264,000 and $583,000 for the three- and six-month periods ended July 3, 2004, respectively, of which $250,000 and $557,000 related directly to products shipped and was charged to cost of revenues from product sales and $14,000 and $26,000 related to professional services provided and was charged to sales and marketing expense.

In exchange for Rustic Canyon forfeiting its right to designate one member to the Company’s Board, on June 26, 2004, the Company granted to Rustic Canyon a warrant to purchase 12,500 shares of the Company’s common stock with a term of five years and an exercise price of $9.31 per share. The fair value of the warrant was estimated on the date of grant using the Black-Scholes multiple option pricing model and the Company recorded $89,000 of stock-based compensation expense, relating to the warrant.

On August 3, 2004, the Company received prepayment in full of the $2.4 million principal amount then outstanding under the five year subordinated secured promissory note from Odimo, together with related accrued interest. In connection with the prepayment, the remaining discount on the note of $217,000 was fully amortized and recorded as interest income.

All statements made in this Quarterly Report on Form 10-Q, other than statements of historical fact, are forward-looking statements. The words “anticipate”, “believe”, “estimate”, “expect”, “intend”, “may”, “plan”, “will”, “would”, “should”, “guidance”, “potential”, “continue”, “project”, “forecast”, “confident”, “prospects”, and similar expressions typically are used to identify forward-looking statements. Forward-looking statements are based on the then-current expectations, beliefs, assumptions, estimates and forecasts about our business and the industries and markets in which we 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 which may affect our business, financial condition and operating results include the effects of changes in the economy, consumer spending, the financial markets and the industries in which we and our partners operate, changes affecting the Internet and e-commerce, our ability to develop and maintain relationships with strategic partners and suppliers and the timing of our establishment or extension of our relationships with strategic partners, our ability to timely and successfully develop, maintain and protect our technology and product and service offerings and execute operationally, our ability to attract and retain qualified personnel, our ability to successfully integrate our acquisitions of other businesses, if any, and the performance of acquired businesses. More information about potential factors that could affect us are described under the heading of “Risk Factors.” We expressly disclaim any intent or obligation to update these forward-looking statements, except as otherwise specifically stated by us.

Comparison of the three- and six-month periods ended June 28, 2003 and July 3, 2004

The following table sets forth the dollar amount and percentage of net revenues for certain line items of our statements of operations for the second quarter of fiscal 2003 and the second quarter of fiscal 2004 and the dollar and percentage change in these line items period over period.

The following table sets forth the dollar amount and percentage of net revenues for certain line items of our statements of operations for the first six months of fiscal 2003 and the first six months of fiscal 2004 and the dollar and percentage change in these line items period over period .

Net revenues from product sales are derived from the sale of goods through our partners’ e-commerce businesses, toll-free telephone number sales, business-to-business and group sales and related outbound shipping charges, net of allowances for returns and discounts.

The following table provides information about our net revenues from product sales by category for the second quarter of fiscal 2003 and the second quarter of fiscal 2004:

The following table provides information about our net revenues from product sales by category for the first six months of fiscal 2003 and the first six months of fiscal 2004:

Net revenues from product sales increased $7.4 million and $20.1 million for the second quarter and first six months of fiscal 2004, respectively, of which $6.6 million and $15.7 million, respectively, was due to increases in sales in the sporting goods category and $834,000 and $4.4 million, respectively, was due to increases in sales in our other product categories, which include consumer electronics, general merchandise and licensed entertainment products. The increases in the sporting goods and other categories were due to the addition of new partners in fiscal 2003, increases in sales from partners’ e-commerce businesses that were operated for the entirety of each of the periods and increases in sales from partners’ e-commerce businesses that were operated for part of the second quarter and first six months of fiscal 2003 and all of the second quarter and first six months of fiscal 2004.

Service fee revenues are derived from fixed and variable fees earned in connection with the development and operation of our partners’ e-commerce businesses and the provision of marketing and other services. Cost of service fee revenues includes the cost of products sold and inbound freight related to those products, as well as outbound shipping and handling costs, other than those related to promotional free shipping and subsidized shipping and handling which would be included in sales and marketing expense. We do not specifically record “Cost of service fee revenues” as these costs are incurred by our fee-based partners rather than by us. Operating expenses relating to service fee revenues consist primarily of personnel and other costs associated with our engineering, production and creative departments which are included in product development expense, as well as fulfillment costs and personnel and other costs associated with our marketing and customer service departments which are included in sales and marketing expense.

Service fee revenues increased $7.0 million and $11.6 million for the second quarter and first six months of fiscal 2004, respectively, due primarily to the launch of new fee-based partners in the second half of fiscal 2003.

Cost of revenues from product sales includes the cost of products sold and inbound freight related to those products, as well as outbound shipping and handling costs, other than those related to promotional free shipping and subsidized shipping and handling which are included in sales and marketing expense.

As a percentage of net revenues from product sales, cost of revenues from product sales was 72.8% and 72.5% for the second quarter and first six months of fiscal 2003, respectively, and 74.5% and 73.7% for the second quarter and first six months of fiscal 2004, respectively. These increases were due primarily to higher product costs in the sporting goods category in the second quarter and first six months of fiscal 2004.

The increases in gross profit dollars for the second quarter and first six months of fiscal 2004 compared to the same periods in fiscal 2003 were due primarily to $7.0 million and $11.6 million increases in service fee revenues in the second quarter and first six months of fiscal 2004, respectively. The increases in gross profit percentage for the second quarter and first six months of fiscal 2004 compared to the same periods in fiscal 2003 were due primarily to the increases in service fee revenues, offset, in part, by lower margins on sales in the sporting goods category in the second quarter and first six months of fiscal 2004.

Sales and marketing expenses include advertising and promotional expenses, including promotional free shipping and subsidized shipping and handling costs, online marketing fees, commissions to participants in the affiliate programs for our partners’ Web sites, fulfillment costs, customer service costs, credit card fees, merchandising costs and payroll and related expenses. These expenses also include partner revenue share charges, which are royalty payments made to our partners in exchange for the use of their brands, the promotion of our partners’ URLs, Web sites and toll-free telephone numbers in their marketing and communications materials, the implementation of programs to provide incentives to customers to shop through the e-commerce businesses that we operate for our partners and other programs and services provided to the customers of the e-commerce businesses that we operate for our partners.

Sales and marketing expenses increased $5.7 million for the second quarter of fiscal 2004 primarily due to a $3.1 million increase in personnel and related costs, of which $1.5 million was attributable to our fulfillment operations and $996,000 was attributable to our customer service department, an $1.1 million increase in advertising costs, a $624,000 increase in credit card fees and a $578,000 increase in subsidized shipping and handling costs. Sales and marketing expenses increased $10.0 million for the first six months of fiscal 2004 primarily due to a $5.1 million increase in personnel and related costs, of which $2.9 million was attributable to our fulfillment operations and $1.5 million was attributable to our customer service department, an $1.9 million increase in advertising costs, a $1.2 million increase in credit card fees, a $689,000 increase in partner revenue share charges and a $652,000 increase in subsidized shipping and handling costs. The increases in personnel and related costs attributable to our fulfillment operations were primarily due to high processing volume in our fulfillment center. The increases in partner revenue share charges and credit card fees were due principally to increased sales volume in the second quarter and first six months of fiscal 2004.

Product development expenses consist primarily of expenses associated with planning, maintaining and operating our partners’ e-commerce businesses and payroll and related expenses for engineering, production, creative and management information systems.

Product development expenses increased $1.1 million for the second quarter of fiscal 2004 primarily due to a $549,000 increase in personnel and related costs and a $403,000 increase in costs related to our use of temporary technical professionals. Product development expenses increased $1.9 million for the first six months of fiscal 2004 primarily due to a $1.1 million increase in costs related to strategic technology planning and our use of temporary technical professionals and a $791,000 increase in personnel and related costs, offset, in part, by a $235,000 decrease in equipment and software maintenance costs.

General and administrative expenses consist primarily of payroll and related expenses for executive, finance, human resources, legal and administrative personnel, as well as bad debt expense and occupancy costs for our headquarters and other offices.

General and administrative expenses increased $918,000 for the second quarter of fiscal 2004 primarily due to a $477,000 increase in personnel and related costs and a $264,000 increase in professional fees. General and administrative expenses increased $1.8 million for the first six months of fiscal 2004 primarily due to a $933,000 increase in personnel and related costs and a $608,000 increase in professional fees.

Stock-based compensation expense consists of the amortization of deferred compensation expense for options granted to employees and certain non-employees, the value of options or warrants granted to certain partners and investors and amortization of deferred partner revenue share charges.

Stock-based compensation expense decreased $251,000 for the second quarter of fiscal 2004 primarily due to a decrease of $352,000 in charges related to options subject to variable accounting and a decrease of $47,000 in charges related to the issuance of options granted during fiscal 2000 and fiscal 2001 with exercise prices below the then-current market prices of the underlying stock, offset, in part, by an increase of $89,000 related to the issuance of a warrant and an increase of $59,000 related to the amortization of deferred partner revenue share charges. Stock-based compensation expense increased $88,000 for the first six months of fiscal 2004 primarily due to an increase of $197,000 related to the amortization of deferred partner revenue share charges and an increase of $89,000 related to the issuance of a warrant, offset, in part, by a decrease of $102,000 in charges related to the issuance of options granted during fiscal 2000 and fiscal 2001 with exercise prices below the then-current market prices of the underlying stock and a decrease of $96,000 in charges related to options subject to variable accounting. As of July 3, 2004, we had an aggregate of $1.1 million of deferred stock-based compensation remaining to be amortized. We had stock-based compensation expense related to the amortization of deferred partner revenue share charges of $273,000 and $495,000 for the second quarter and first six months of fiscal 2003, respectively, and $332,000 and $692,000 for the second quarter and first six months of fiscal 2004, respectively.

Depreciation and amortization expenses relate primarily to the depreciation of our corporate headquarters and Kentucky fulfillment center, the depreciation and amortization of the capitalized costs for our purchased and internally developed technology, including a portion of the cost related to the employees that developed such technology, hardware and software and the depreciation of improvements, furniture and equipment at our corporate headquarters and our fulfillment and customer contact centers.

Depreciation and amortization expenses decreased $88,000 for the second quarter of fiscal 2004 and decreased $187,000 for the first six months of fiscal 2004 primarily due to certain previously purchased assets becoming fully depreciated in fiscal 2003, offset, in part, by additional assets to build, manage and operate our business.

Interest income consists primarily of interest earned on cash, cash equivalents, short-term investments and marketable securities. Interest expense consists of interest paid in connection with the mortgage note on our new corporate headquarters.

The decreases in interest income of $48,000 and $139,000 for the second quarter and first six months of fiscal 2004, respectively, were due lower average balances of cash, cash equivalents, short-term investments and marketable securities, offset, in part, by higher interest rates during the second quarter and first six months of fiscal 2004 compared to the same periods in fiscal 2003.

The increases in interest expense of $54,000 for the second quarter and first six months of fiscal 2004, respectively, were due to interest incurred on the $13.0 million mortgage note on our new corporate headquarters which was entered into on June 9, 2004.

Since the sales of our discontinued operations in fiscal 1999 and fiscal 2000, we have not generated taxable income. Net operating losses generated have been carried back to offset income taxes paid in prior years. The remaining net operating losses will be carried forward. As of July 3, 2004, we had available net operating loss carryforwards of approximately $428.1 million which expire in the years 2004 through 2023. The use of certain net operating loss carryforwards are subject to annual limitations based on ownership changes of our stock, as defined by Section 382 of the Internal Revenue Code. We expect that net operating losses of approximately $243.2 million will expire before they can be used. Any otherwise recognizable deferred tax assets have been offset by a valuation allowance for the net operating loss carryforwards.

We have entered into a strategic alliance to provide technology, procurement and fulfillment services for QVC, Inc. Interactive Technology Holdings, LLC, which is one of our major stockholders, is a joint venture company of Comcast Corporation and QVC. We recognized net revenues on sales to this related party of $460,000 and $986,000 for the second quarter and first six months of fiscal 2003, respectively, and $238,000 and $571,000 for the second quarter and first six months of fiscal 2004, respectively. The terms of these sales are comparable to those with our other business-to-business partners. As of July 3, 2004, the amount included in accounts receivable was $333,000 related to these sales.

In fiscal 2003, we entered into an agreement with QVC pursuant to which QVC will provide shipping services to us in exchange for variable fees. We incurred fees of $0 for the second quarter and first six months of fiscal 2003, respectively. We incurred fees of $264,000 and $583,000 for the second quarter and first six months of fiscal 2004, of which $250,000 and $557,000 related directly to products shipped and was charged to cost of revenues from product sales and $14,000 and $26,000 related to professional services provided and was charged to sales and marketing expense.

In exchange for Rustic Canyon forfeiting its right to designate one member to our Board, on June 26, 2004, we granted to Rustic Canyon a warrant to purchase 12,500 shares of our common stock with a term of five years and an exercise price of $9.31 per share. The fair value of the warrant was estimated on the date of grant using the Black-Scholes multiple option pricing model and we recorded $89,000 of stock-based compensation expense, relating to the warrant.

Our principal source of liquidity is our cash, cash equivalents and marketable securities. Our cash, cash equivalents and marketable securities balances were $69.5 million and $48.2 million as of January 3, 2004 and July 3, 2004, respectively.

We raised an aggregate of $176.3 million in gross proceeds through equity financings in fiscal 1999, fiscal 2000 and fiscal 2001, as well as $5.3 million in gross proceeds through a mortgage financing in fiscal 2000. We received an aggregate of $23.5 million in proceeds from the sales of our discontinued operations in fiscal 1999 and fiscal 2000, as well as $35.7 million in net cash from the acquisition of Fogdog in fiscal 2000.

We have incurred substantial costs to develop our e-commerce platform and to recruit, train and compensate personnel for our creative, engineering, business development, marketing, merchandising, customer service, management information systems and administrative departments. During the first and second quarters of fiscal 2004, we spent approximately $4.9 million on continued upgrades to our technology infrastructure and $1.2 million on warehouse equipment and improvements for our Kentucky fulfillment center. Also, during the second quarter of fiscal 2004, we spent approximately $17.5 million to purchase our new corporate headquarters in King of Prussia, Pennsylvania. We expect to spend $5.0 to $6.0 million in building improvements to our new headquarters. We expect additional capital expenditures for fiscal 2004 to be between $6.4 and $11.4 million as we continue to improve our technology infrastructure and invest in our fulfillment and customer contact center operations. As of July 3, 2004, we had working capital of $24.5 million and an accumulated deficit of $184.8 million.

We used approximately $12.4 million in net cash for operating activities during the first six months of fiscal 2004. Our principal sources of operating cash during the first six months of fiscal 2004 were payments received from customers and fee-based partners, which generally approximate our net revenues from product sales and our service fee revenues, respectively. Our principal uses of operating cash during the first six months of fiscal 2004 were cash paid to product suppliers, which generally approximates our cost of revenues from product sales, employee compensation and partner revenue share payments. Changes in our operating assets and liabilities during the first six months of fiscal 2004 resulted in a net cash outflow of $11.2 million. The most significant changes were a decrease in accounts payable, accrued expenses and other, a decrease in deferred revenue and an increase in accounts receivable compared to the end of fiscal 2003. The decrease in accounts payable, accrued expenses and other was due primarily to a decrease in operating accounts payable related to decreased sales volume compared to the fourth quarter of fiscal 2003. The decrease in deferred revenue was due to a decrease in service fees paid to us in advance by certain partners. The increase in accounts receivable was due primarily to decreases in our accounts receivable reserves. Our investing activities during the first six months of fiscal 2004 consisted primarily of the purchase of our new corporate headquarters and other capital expenditures totaling approximately $23.7 million. During the first six months of fiscal 2004, we also purchased $6.1 million and sold $2.6 million of marketable securities. Our financing activities during the first six months of fiscal 2004 consisted primarily of the receipt of $13.0 million in gross proceeds from a mortgage note on our new corporate headquarters.

We used approximately $23.8 million in net cash for operating activities during the first six months of fiscal 2003. Our principal sources of operating cash during the first six months of fiscal 2003 were payments received from customers and fee-based partners. Our principal uses of operating cash during the first six months of fiscal 2003 were cash paid to product suppliers,

employee compensation and partner revenue share payments. Changes in our operating assets and liabilities during the first six months of fiscal 2003 resulted in a net cash outflow of $20.7 million. The most significant changes were a decrease in accounts payable, accrued expenses and other, offset, in part, by a decrease in inventory compared to the end of fiscal 2002. The decrease in accounts payable, accrued expenses and other was due primarily to a decrease in trade accounts payable due primarily to lower inventory levels at the end of the second quarter of fiscal 2003. The increase in deferred revenue was due primarily to an increase in service fees paid to us in advance by certain partners. During the first six months of fiscal 2003, we purchased $9.6 million and sold $9.6 million of marketable securities, incurred capital expenditures of $2.2 million and received $891,000 in gross proceeds from sales of short-term investments.

To date, we have financed our e-commerce operations primarily from the sale of equity securities. Management expects that our current cash and the collection of accounts receivable will be sufficient to meet our anticipated cash needs for the foreseeable future. While in the fourth quarter of fiscal 2003 we realized net income of $2.7 million and in the fourth quarter of fiscal 2001 we realized net income of $260,000, we did not realize net income for the full years of fiscal 2001, fiscal 2002 or fiscal 2003. While we do expect to realize net income in fiscal 2004, in order to fund our anticipated operating expenses and realize income, our revenues must increase significantly. If cash flows are insufficient to fund our expenses, we may need to raise additional funds in future periods through public or private debt or equity financings or other arrangements to fund our operations until we achieve profitability. Failure to raise future capital when needed could seriously harm our business and operating results. If additional funds are raised through the issuance of equity securities, the percentage ownership of our current stockholders would be reduced to the extent they did not participate in that financing. Furthermore, these equity securities might have rights, preferences or privileges senior to our common stock.

We have experienced and expect to continue to experience seasonal fluctuations in our revenues. These seasonal patterns will cause quarterly fluctuations in our operating results. In particular, our fourth fiscal quarter has accounted for and is expected to continue to account for a disproportionate percentage of our total annual revenues. We believe that results of operations for a quarterly period may not be indicative of the results for any other quarter or for the full year.

Any investment in our common stock or other securities involves a high degree of risk. You should carefully consider the following information about these risks, together with the other information contained in this Quarterly Report on Form 10-Q. If any of the following risks occur, our business could be materially harmed. In these circumstances, the market price of our common stock could decline, and you may lose all or part of the money you paid to buy our common stock.

All statements made in this Quarterly Report on Form 10-Q, other than statements of historical fact, are forward-looking statements. The words “anticipate”, “believe”, “estimate”, “expect”, “intend”, “may”, “plan”, “will”, “would”, “should”, “guidance”, “potential”, “continue”, “project”, “forecast”, “confident”, “prospects”, and similar expressions typically are used to identify forward-looking statements. Forward-looking statements are based on the then-current expectations, beliefs, assumptions, estimates and forecasts about our business and the industries and markets in which we 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 which may affect our business, financial condition and operating results include the effects of changes in the economy, consumer spending, the financial markets and the industries in which we and our partners operate, changes affecting the Internet and e-commerce, our ability to develop and maintain relationships with strategic partners and suppliers and the timing of our establishment or extension of our relationships with strategic partners, our ability to timely and successfully develop, maintain and protect our technology and product and service offerings and execute operationally, our ability to attract and retain qualified personnel, our ability to successfully integrate our acquisitions of other businesses, if any, and the performance of acquired businesses. More information about potential factors that could affect us is provided below. We expressly disclaim any intent or obligation to update these forward-looking statements, except as otherwise specifically stated by us.

Our future success cannot be predicted based upon our limited operating history.

Compared to certain of our current and potential competitors, we have a relatively short operating history. In addition, the nature of our business has undergone rapid development and change since we began operating it. Accordingly, it is difficult to predict whether we will be successful. Thus, our chances of financial and operational success should be evaluated in light of the risks, uncertainties, expenses, delays and difficulties associated with operating a business in a relatively new and unproven market or a new business in an existing market, many of which may be beyond our control. If we are unable to address these issues, we may not be financially or operationally successful.

We incurred substantial losses over the past five fiscal years while operating our business. As of the end of the second quarter of fiscal 2004, we had an accumulated deficit of $184.8 million. We may not obtain an appropriate volume of purchases through our e-commerce platform, generate an appropriate amount of service fee revenue from our existing partners, add an appropriate amount of new partners to generate sufficient revenues or adequately control our expenses in order to achieve profitability. While we expect to be profitable in fiscal 2004, there can be no assurances that we will be able to achieve profitability.

We will continue to incur significant operating expenses and capital expenditures as we:

Because we will incur many of these expenses before we receive any revenues from our efforts, our losses will be greater than the losses we would incur or our profits will be less than we would generate if we developed our business more slowly. In addition, we may find that these efforts are more expensive or less productive than we currently anticipate, which could further increase our losses. Also, the timing of these expenses may contribute to fluctuations in our quarterly operating results.

We have recently expanded our operations into new categories. If we do not successfully expand our operations into these new categories, our growth could be limited.

Until fiscal 2001, our business was limited to sporting goods. Today, our operations have expanded into other categories, including consumer electronics, home products, apparel and footwear, beauty products and licensed entertainment merchandise. In order to successfully expand our business into these and other categories, we must develop and maintain relationships with manufacturers and other suppliers in those categories and hire and retain skilled personnel to help manage these areas of our business. Our failure to successfully expand our business into these and other categories could limit our ability to increase revenues and attract new partners.

Our success is tied to the success of the partners for which we operate e-commerce businesses.

Our future success is substantially dependent upon the success of the partners for which we operate e-commerce businesses. If our partners were to have financial difficulties or seek protection from their creditors or if they were to suffer impairment of their brand, or if we are unable to replace our partners or obtain new partners, it could adversely affect our ability to grow our business. The growth of our business could also be adversely affected if our partners’ marketing, brands or retail stores are not successful or if our partners reduce their marketing investment or number of retail stores.

Our revenue and rate of growth depends on the continued growth of demand for the products offered by us, and our business is affected by general economic and business conditions. A decrease in demand, whether caused by changes in consumer spending or a weakening of the U.S. economy or the local economies outside of the United States where we also sell products, may result in decreased revenue or growth. Terrorist attacks and armed hostilities create economic and consumer uncertainty that could adversely affect our revenue or growth.

We have an e-commerce agreement with Bluelight.com, a subsidiary of Kmart, pursuant to which we operate the Kmart.com Web site. Even though Kmart and Bluelight emerged from bankruptcy in 2003, we may not realize all of the economic benefits of that agreement.

Kmart, as well as Bluelight.com, operated in bankruptcy from January 2002 until May 2003. In connection with its bankruptcy restructuring plan, Bluelight assumed its e-commerce agreement with us. In March 2003, we and Bluelight modified our agreement to shorten the term, eliminate the last two of eight fixed fee payments required under the agreement and provide for early termination rights for both us and Bluelight. We will, however, continue to receive a percentage of sales through the Bluelight Web site for the services that we provide under this agreement. Bluelight.com may terminate its agreement with us early. If Bluelight.com terminates its agreement with us, we will not realize all of the economic benefits of that agreement.

We enter into contracts with our partners. Some of these partners’ online retail stores account for a significant portion of our revenue. If we do not maintain good working relationships with our partners or perform as required under these agreements, it could adversely affect our business. Additionally, if our partners terminate their contracts with us due to our failure to cure contractual breaches, it could negatively affect our business.

The contracts with our partners establish complex relationships between our partners and us. We spend a significant amount of time and effort to maintain our relationships with our partners and address the issues that from time to time may arise from these complex relationships. For fiscal 2003, sales to customers through one of our partner’s e-commerce businesses accounted for 28% of our revenue, sales through another one of our partner’s e-commerce businesses accounted for 17% of our revenue and sales through our top five partners’ e-commerce businesses accounted for 70% of our revenue. For fiscal 2002, sales to customers through one of our partner’s e-commerce businesses accounted for 20% of our revenue, sales to customers through another one of our partner’s e-commerce businesses accounted for 12% of our revenue, sales to Kmart as well as related service fees accounted for 14% of our revenue, and sales through our top four partners’ e-commerce businesses and sales to Kmart accounted for 56.4% of our revenue. If we do not maintain good working relationships with our partners, our partners could decide not to renew their agreements at the end of the term. Additionally, if we do not perform as required under these agreements, our partners could seek to terminate their agreements prior to the end of the term. This could adversely affect our business, financial condition and results of operations. Moreover, our partners could decide not to renew these contracts for reasons not related to our performance.

Our operating results have and may continue to fluctuate significantly, which may cause the market price of our common stock to be volatile.

Our annual and quarterly operating results have and may continue to fluctuate significantly due to a variety of factors, many of which are outside of our control. Because our operating results may be volatile and difficult to predict, quarter-to-quarter comparisons of our operating results may not be a good indication of our future performance. In some future quarter, our operating results may also fall below our expectations and the expectations of securities analysts and investors which likely will cause the market price of our common stock to decline significantly.

Factors that may cause our operating results to fluctuate or harm our business include but are not limited to the following:

Seasonal fluctuations in sales could cause wide fluctuations in our quarterly results.

We have experienced and expect to continue to experience seasonal fluctuations in our revenues. These seasonal patterns have caused and will cause quarterly fluctuations in our operating results. In particular, our fourth fiscal quarter has accounted for and is expected to continue to account for a disproportionate percentage of our total annual revenues. In anticipation of increased sales activity during our fourth fiscal quarter, we typically hire a significant number of temporary employees to supplement our permanent staff and significantly increase our inventory levels. For this reason, if our revenues are below seasonal expectations during the fourth fiscal quarter, our operating results could be below the expectations of securities analysts and investors. If our revenues exceed seasonal expectations during the fourth quarter, it could put significant strain on our fulfillment and customer service operations.

Due to the nature of our business, it is difficult to predict the seasonal pattern of our sales and the impact of this seasonality on our business and financial results. In the future, our seasonal sales patterns may become more pronounced, may strain our personnel, product distribution and shipment activities and may cause a shortfall in revenues as compared to expenses in a given period.

We have been unable to fund our e-commerce operations with the cash generated from our business. If we do not generate cash sufficient to fund our operations, we may in the future need additional financing to continue our growth or our growth may be limited.

Because we have not generated sufficient cash from operations to date, we have funded our e-commerce business primarily from the sale of equity securities. Cash from revenues must increase significantly for us to fund anticipated operating expenses internally. If our cash flows are insufficient to fund these expenses, we may in the future need to fund our growth through additional equity or debt financings or reduce costs. Further, we may not be able to obtain financing on satisfactory terms. Our inability to finance our growth, either internally or externally, may limit our growth potential and our ability to execute our business strategy. If we issue securities to raise capital, our existing stockholders may experience dilution or the new securities may have rights senior to those of our common stock.

We and our partners must develop and maintain relationships with key manufacturers to obtain a sufficient assortment and quantity of quality merchandise on acceptable commercial terms. If we or our partners are unable to do so, it could adversely affect our business, results of operations and financial condition.

For the categories in which we own inventory, we primarily purchase products from the manufacturers and distributors of the products. For the categories in which we provide e-commerce services to our partners, our partners purchase products from the manufacturers and distributors of products. If we or our partners are unable to develop and maintain relationships with these manufacturers, we or our partners may be unable to obtain or continue to carry a sufficient assortment and quantity of quality merchandise on acceptable commercial terms and our business could be adversely impacted. We do not have written contracts with many manufacturers or distributors. During the fiscal 2003, we purchased 37% of the total amount of inventory we purchased from one manufacturer. In addition, during fiscal 2002, we purchased 20% of the total amount of inventory we purchased from one manufacturer and during fiscal 2001, we purchased 23% and 16% of the total amount of inventory we

purchased from two manufacturers. Manufacturers could stop selling products to our partners or us and may ask us or our partners to remove their products or logos from our partners’ Web sites. If our partners or we are unable to obtain products directly from manufacturers, especially popular brand manufacturers, we may not be able to obtain the same or comparable merchandise in a timely manner or on acceptable commercial terms.

We may not be successful in finding, developing and marketing products that consumers of the direct response television campaigns we operate will want to purchase.

For the direct response television campaigns we operate or for which we provide services, our success depends on our ability to find, develop and market products that consumers will want to purchase. We promote these products on our partners’ Web sites as well as through direct response television programming. If we do not select products that consumers want to purchase, this could result in lost opportunities which could reduce sales.

We may be unable to source product for direct response television campaigns on favorable terms. Additionally, we may not be successful in selling the products we source at a profit or at all.

For direct response television campaigns, our financial performance depends on our ability to develop products or acquire the rights to products that will be appealing to consumers. We select products based on management’s retail experience. We may not be successful in finding and sourcing products that consumers will want to purchase. Any failure to meet consumers’ desires could result in lost opportunities and excess inventory which could reduce our revenues. Additionally, we may select products that are not profitable which could result in lower margins.

Capacity constraints or system failures could materially and adversely affect our business, results of operations and financial condition.

Any system failure, including network, telecommunications, software or hardware failure, that causes interruption of the availability of our partners’ e-commerce businesses could result in decreased usage and sales. If these failures are sustained or repeated, they could reduce the attractiveness of our partners’ e-commerce businesses to customers, vendors and advertisers. Our operations are subject to damage or interruption from:

The inherent unpredictability of these events makes it difficult to predict whether the occurrence of any of these events is likely. If any of these events does occur, it could result in interruptions, delays or cessations in service to customers of our partners’ e-commerce businesses.

In addition, we maintain the computers on which we operate our partners’ e-commerce businesses at two facilities of a third-party hosting company. We cannot control the security, maintenance or operation of these facilities, which is also susceptible to similar disasters and problems. Our insurance policies may not adequately compensate us for any losses that we may incur. Any system failure that causes an interruption in our service or a decrease in responsiveness could harm our relationships with our customers, partners and vendors and result in reduced revenues.

We may be unable to protect our proprietary technology or keep up with that of our competitors.

Our success depends to a significant degree upon the protection of our software and other proprietary intellectual property rights. We may be unable to deter misappropriation of our proprietary information, detect unauthorized use or take appropriate steps to enforce our intellectual property rights. In addition, our competitors could, without violating our proprietary rights, develop technologies that are as good as or better than our technology.

Our failure to protect our software and other proprietary intellectual property rights or to develop technologies that are as good as our competitors’ could put us at a disadvantage to our competitors. In addition, the failure of our partners to protect their intellectual property rights, including their trademarks and domain names, could impair our operations. These failures could have a material adverse effect on our ability to generate revenues.

If we do not respond to rapid technological changes, our services could become obsolete and we could lose customers.

Due to the costs and management time required to introduce new services, products and enhancements, we may be unable to respond to rapid technological changes in a timely enough manner to avoid our services becoming uncompetitive. If this happens, our customers may forgo the use of our services or our partners’ e-commerce businesses and use those of our competitors. To remain competitive, we must continue to enhance and improve the functionality and features of our partners’ e-commerce businesses. The Internet and e-commerce are constantly changing. If competitors introduce new products and services using new technologies or if new industry standards and practices emerge, our partners’ existing e-commerce businesses and our services and proprietary technology and systems may become uncompetitive.

Developing our services offering, our partners’ e-commerce businesses and other proprietary technology entails significant technical and business risks. We may use new technologies ineffectively or we may fail to adapt our services offering, our partners’ e-commerce businesses, and our technology to meet customer requirements or emerging industry standards. Additionally, the technology vendors we use for our partners’ e-commerce businesses may not provide the level of service we expect or may not be available on commercially reasonable terms, if at all.

We may be subject to intellectual property claims or competition or trade practices claims that could be costly and could disrupt our business.

Third parties may assert that our business or technologies infringe their intellectual property rights. From time to time, we may receive notices from third parties questioning our right to offer certain services or products or to present specific images or logos on our partners’ e-commerce businesses, or stating that we have infringed their patents, trademarks, copyrights or other rights. We may in the future receive claims that we are engaging in unfair competition or other illegal trade practices. We may be unsuccessful in defending against these claims, which could result in substantial damages, fines or other penalties. The resolution of a claim could also require us to change how we do business, redesign our service offering or partners’ e-commerce businesses or enter into burdensome royalty or licensing agreements. These license or royalty agreements, if required, may not be available on acceptable terms, if at all, in the event of a successful claim of infringement. Our insurance coverage may not be adequate to cover every claim that third parties could assert against us. Even unsuccessful claims could result in significant legal fees and other expenses, diversion of management’s time and disruptions in our business. Any of these claims could also harm our reputation.

We rely on our ability to enter into marketing and promotion agreements with online services, search engines, directories and other Web sites to drive traffic to the e-commerce businesses we operate. If we are unable to enter into or properly develop these marketing and promotional agreements, our ability to generate revenue could be adversely affected.

We have entered into marketing and promotion agreements with online services, search engines, directories and other Web sites to provide content, advertising banners and other links that link to our partners’ e-commerce businesses. We expect to rely on these agreements as significant sources of traffic to our partners’ e-commerce businesses and to generate new customers. If we are unable to enter into satisfactory agreements on acceptable terms, our ability to attract new customers could be harmed. Further, many of the parties with which we may have online advertising arrangements could provide advertising services for other marketers of goods. As a result, these parties may be reluctant to enter into or maintain relationships with us. Failure to achieve sufficient traffic or generate sufficient revenue from purchases originating from third parties may result in termination of these types of agreements. Without these relationships, we may not be able to sufficiently increase our market share and revenue.

Our success depends to a significant degree upon the contribution of our executive officers and other key personnel, particularly Michael G. Rubin, Chairman, Co-President and Chief Executive Officer. We have employment agreements with certain of our executive officers and key personnel. Due to the costs associated with compensating executive officers and key personnel and the competition for highly qualified personnel, we cannot be sure that we will be able to retain or attract executive, managerial or other key personnel. We have obtained key person life insurance for Mr. Rubin in the amount of $9.0 million. We have not obtained key person life insurance for any of our other executive officers or key personnel.

We may be unable to hire and retain the skilled personnel necessary to develop our business.

We intend to continue to hire a significant number of skilled personnel. Due to intense competition for these individuals from our competitors and other employers, we may not be able to attract, assimilate or retain highly qualified personnel in the future. Our failure to attract and retain the experienced and highly trained personnel that are integral to our business may limit our growth.

We may not be able to compete successfully against current and future competitors, which could harm our margins and our business.

E-commerce and the provision of e-commerce services are constantly evolving and are extremely competitive. Increased competition could result in fewer successful outsourced opportunities, price reductions, reduced gross margins and loss of market share, any of which could seriously harm our business, financial condition and results of operations. We primarily compete with companies who can offer a full range of e-commerce services similar to the services we provide through our e-commerce platform, such as Amazon.com, Digital River, Foot Locker (principally in the sporting goods category) and ValueVision. We also compete with companies that can provide some of the components similar to those that we offer through our e-commerce platform, including Web site developers, third-party consultants and third-party fulfillment and customer service providers. We also compete with companies that may choose to develop and operate their e-commerce businesses in-house and the online and offline businesses of a variety of retailers and manufacturers.

If we experience problems in our fulfillment, warehouse and distribution operations, we could lose customers.

Although we operate our own fulfillment center, we rely upon multiple third parties for the shipment of our products. We also rely upon certain vendors to ship products directly to our customers. As a result, we are subject to the risks associated with the ability of these vendors to successfully and timely fulfill and ship customer orders and to successfully handle our inventory delivery services to meet our shipping needs. The failure of these vendors to provide these services, or the termination or interruption of these services, could adversely affect the satisfaction of our customers, which could result in reduced sales.

Consumers are constantly changing their buying preferences. If we fail to anticipate these changes, we could experience lower sales, higher inventory markdowns and lower margins for the inventory that we own.

Our success depends, in part, upon our ability and our partners’ ability to anticipate and respond to consumer trends with respect to products sold through the e-commerce businesses we operate. Consumers’ tastes are subject to frequent and significant changes. In order to be successful, our partners and we must accurately predict consumers’ tastes and avoid overstocking or understocking products. If we fail to identify and respond to changes in merchandising and consumer preferences, our sales could suffer and we could be required to mark down unsold inventory. If our partners fail to identify and respond to changes in merchandising and customer preferences, our sales could suffer. This would depress our profit margins. In addition, any failure to keep pace with changes in consumers’ tastes could result in lost opportunities which could reduce sales.

High merchandise returns could adversely affect our business, financial condition and results of operations.

Our policy for allowing our customers to return products is generally consistent with the policies of each of our partners for which we operate e-commerce businesses. If merchandise returns are significant, our revenues and expenses related to our fulfillment center could be adversely affected.

We may be subject to product liability claims that could be costly and time-consuming.

We sell products manufactured by third parties, some of which may be defective. We also sell some products that are manufactured by third parties for us. If any product that we sell were to cause physical injury or injury to property, the injured party or parties could bring claims against us as the retailer of the product. Our insurance coverage may not be adequate to cover every claim that could be asserted. Similarly, we could be subject to claims that customers of our partners’ e-commerce businesses were harmed due to their reliance on our product information, product selection guides, advice or instructions. If a successful claim were brought against us in excess of our insurance coverage, it could adversely affect our business. Even unsuccessful claims could result in the expenditure of funds and management time and could have a negative impact on our business.

We may be liable if third parties misappropriate our customers’ personal information.

If third parties are able to penetrate our network or telecommunications security or otherwise misappropriate our customers’ personal information or credit card information or if we give third parties improper access to our customers’ personal information or credit card information, we could be subject to liability. This liability could include claims for unauthorized purchases with credit card information, impersonation or other similar fraud claims. They could also include claims for other misuses of personal information, including unauthorized marketing purposes. These claims could result in litigation. Liability for misappropriation of this information could be significant. In addition, the Federal Trade Commission and state agencies regularly investigate various companies’ use of customers’ personal information. We could incur additional expenses if new regulations regarding the use of personal information are introduced or if government agencies investigate our privacy practices.

From time to time, we may acquire or invest in other companies. There are risks associated with potential acquisitions and investments. As a result, we may not achieve the expected benefits of potential acquisitions.

If we are presented with appropriate opportunities, we may make investments in complementary companies, products or technologies or we may purchase other companies. We may not realize the anticipated benefits of any investment or acquisition. We may not be able to successfully assimilate the additional personnel, operations, acquired technology or products or services into our business. Any acquisition may further strain our existing financial and managerial controls and reporting systems and procedures. If we do not successfully integrate any acquired business, the expenditures on integration efforts will reduce our cash position without us being able to realize the expected benefits of the merger. In addition, key personnel of an acquired company may decide not to work for us. These difficulties could disrupt our ongoing business, distract our management and employees and increase our expenses. Further, the physical expansion in facilities that would occur as a result of any acquisition may result in disruptions that could seriously impair our business. Finally, we may have to incur debt or issue additional equity securities to pay for other acquisitions or investments, the issuance of which could be dilutive to our stockholders.

The consideration we received in exchange for the sale of certain assets related to Ashford.com, Inc. may be subject to a number of risks.

In connection with the sale of certain assets of Ashford.com to Odimo Acquisition Corp., we received equity securities and an earn out that is dependent on Odimo’s consolidated earnings. Fluctuations in the value of these securities and Odimo’s performance will affect our actual realization of the amounts we expect to receive from this sale. Further, as an observable market price does not exist for equity securities of Odimo as it is a private company, our estimates of fair value of such securities are more subjective than for the securities of public companies.

There are certain risks as a result of litigation pending or threatened against Ashford.com at the time of the acquisition and with respect to which Ashford.com may be liable.

While we sold certain assets of Ashford.com in December 2002, Ashford.com continues to be a party to certain litigation that was commenced prior to our acquisition of Ashford.com in March 2002. Since July 11, 2001, several stockholder class action complaints have been filed in the United States District Court of the Southern District of New York against Ashford.com, several of Ashford.com’s officers and directors, and various underwriters of Ashford.com’s initial public offering. The purported class actions have all been brought on behalf of purchasers of Ashford.com common stock during various periods beginning on September 22, 1999, the date of Ashford.com’s initial public offering. The plaintiffs allege that Ashford.com’s prospectus, included in Ashford.com’s Registration Statement on Form S-1 filed with the Securities and Exchange Commission, was materially false and misleading because it failed to disclose, among other things, certain fees and commissions collected by the underwriters or arrangements designed to inflate the price of the common stock. The plaintiffs further allege that because of these purchases, Ashford.com’s post-initial public offering stock price was artificially inflated. As a result of the alleged omissions in the prospectus and the purported inflation of the stock price, the plaintiffs claim violations of Sections 11 and 15 of the Securities Act of 1933 and Section 10(b) of the Securities Exchange Act of 1934. The complaints have been consolidated into a single action, and the consolidated cases against Ashford.com have been consolidated with similarly consolidated cases filed against 308 other issuer defendants for the purposes of pretrial proceedings. The claims against Ashford.com’s officers and directors were dismissed in exchange for tolling agreements which permit the refiling of claims against officers and directors at a later date. A motion to dismiss filed on behalf of all issuer defendants, including Ashford.com, was denied in all aspects relevant to Ashford.com on February 19, 2003. Ashford.com and its insurers have entered into a memorandum of understanding regarding terms for settlement of this suit. Under the settlement, plaintiffs’ claims against Ashford.com and other issuers will be dismissed in exchange for certain consideration from the issuers’ insurers and for the issuers’ assignment to plaintiffs of certain potential claims against the underwriters of the relevant initial public offerings. Formal documentation of the settlement contemplated by the memorandum of understanding is complete and is pending approval by the judge presiding over this matter. In the event that a settlement is not finalized, we believe that Ashford.com has defenses against these actions.

We may expand our business internationally, causing our business to become increasingly susceptible to numerous international business risks and challenges that could affect our profitability.

We believe that the current globalization of the economy requires businesses to consider pursuing international expansion. We recently began shipping certain products to Canada. In the future, we may expand into other international markets. International sales are subject to inherent risks and challenges that could adversely affect our profitability, including:

Any negative impact on our international business could negatively impact our business, operating results and financial condition as a whole. In particular, gains and losses on the conversion of foreign payments into United States dollars may contribute to fluctuations in our results of operations and fluctuating exchange rates could cause reduced revenues and/or gross margins from non-dollar-denominated international sales.

Our success is tied to the continued growth in the use of the Internet and the adequacy of the Internet infrastructure.

Our future success is substantially dependent upon continued growth in the use of the Internet. The number of users and advertisers on the Internet may not increase and commerce over the Internet may not continue to grow for a number of reasons, including:

Published reports have also indicated that growth in the use of the Internet has resulted in users experiencing delays, transmission errors and other difficulties. As currently configured, the Internet may not support an increase in the number or requirements of users. In addition, there have been outages and delays on the Internet as a result of damage to the current infrastructure. The amount of traffic on our partners’ Web sites could be materially affected if there are outages or delays in the future. The use of the Internet may also decline if there are delays in the development or adoption of modifications by third parties that are required to support increased levels of activity on the Internet. If any of the foregoing occurs, or if the Internet does not become a viable commercial medium, the number of our customers could decrease. In addition, we may be required to spend significant capital to adapt our operations to any new or emerging technologies relating to the Internet.

The technology of the Internet is changing rapidly and could render the e-commerce businesses which we operate obsolete.

The technology of the Internet and online retailing is evolving rapidly for many reasons, including:

If the costs associated with the changing technology of the Internet prevents us from enhancing our e-commerce platform, those businesses could become less effective, which would reduce our competitive advantage and put our ability to attract and retain customers at risk. Therefore, the potential negative impact of these businesses becoming less effective would affect us to a greater extent than it would affect a company that has other significant channels for the sale or distribution of its products.

In order to keep the Web sites that we operate from becoming obsolete, and maintain our ability to attract and retain customers, we must accomplish the following tasks:

Our long-term future depends heavily upon the general public’s willingness to use the Internet as a means to purchase goods. The failure of the Internet to continue to develop as an effective commercial tool would seriously damage our future operations. E-commerce is still a relatively new concept, and large numbers of customers may not begin or continue to use the Internet to purchase goods. The demand for and acceptance of products sold over the Internet are highly uncertain, and most e-commerce businesses have a short track record. If consumers are unwilling to use the Internet to conduct business, our business may not develop profitably. The Internet may not succeed as a medium of commerce because of delays in developing elements of the needed Internet infrastructure, such as a reliable network, high-speed modems, high-speed communication lines and other enabling technologies.

The security risks of online retailing may discourage customers from purchasing goods from us.

In order for e-commerce to develop successfully, we and other market participants must be able to transmit confidential information securely over public networks. Third parties may have the technology or know-how to breach the security of customer transaction data and store confidential information on our own servers. Any breach could cause customers to lose confidence in the security of our partners’ e-commerce businesses and choose not to purchase from those businesses. If someone is able to circumvent our security measures, he or she could destroy or steal valuable information or disrupt the operation of our partners’ e-commerce businesses. Concerns about the security and privacy of transactions over the Internet could inhibit the growth of the Internet and e-commerce. Our security measures may not effectively prohibit others from obtaining improper access to the information on our partners’ e-commerce businesses. Any security breach could expose us to risks of loss, litigation and liability and could seriously disrupt our operations.

We need to continuously acquire and effectively use entertainment space to market and sell our direct response television campaign products.

We generally enter into agreements with entertainment companies, branded manufacturers and other sellers of products to run their e-commerce businesses, including some of their direct response television campaigns. In those agreements, the entertainment companies, branded manufacturers and other sellers of products generally agree to certain marketing, advertising and air-time commitments for the promotion of products sold through their e-commerce businesses, including direct response television and online retail stores. Air-time is very valuable and is essential for the success of direct response television campaigns. If we are unable to negotiate favorable marketing, advertising and air-time commitments in our agreements with our partners or if our partners do not fulfill their commitments, the amount of products we could sell likely would be lower which would cause our revenues to be lower.

We do not carry insurance against the risk of credit card fraud and other fraud, so the failure to adequately control fraudulent transactions could increase our general and administrative expenses. With respect to credit card fraud, we have put in place technology and processes to help us detect the fraudulent use of credit card information. With respect to other fraud, such as fraud related to checks and installment sales, we use third-party service providers to help us detect fraud. To date, we have not suffered material losses due to fraud. However, we may in the future suffer losses as a result of orders placed with fraudulent credit card data even though the associated financial institution or third-party service provider approved payment of the orders. Under current credit card practices, we are liable for fraudulent credit card transactions because we do not obtain a cardholder’s signature. With respect to checks and installment sales, generally we are liable for fraudulent transactions.

If one or more states successfully assert that we should collect sales or other taxes on the sale of our merchandise, our business could be harmed.

We currently only collect sales or other similar taxes for goods sold by us and shipped into certain states. One or more local, state or foreign jurisdictions may seek to impose sales tax collection obligations on us or our partners and other out-of-state companies that engage in e-commerce. Recently, certain large retailers, such as Wal-Mart, Target and Toys “R” Us, expanded their collection of sales tax on purchases made through affiliated Web sites. Our business could be adversely affected if one or more states or any foreign country successfully asserts that we should collect sales or other taxes on the sale of merchandise through the e-commerce businesses we operate.

In September 2003, we learned that we, along with several of our partners, were named in an action in the Circuit Court of Cook County, Illinois, by a private litigant who is alleging that we, along with certain of our partners, wrongfully failed to collect and remit sales and use taxes for sales of personal property to customers in Illinois and knowingly created records and statements falsely stating we were not required to collect or remit such taxes. The complaint seeks injunctive relief, unpaid taxes, interest, attorneys’ fees, civil penalties of up to $10,000 per violation, and treble damages under the Illinois Whistleblower Reward and Protection Act. We are aware that this same private litigant has filed similar actions against retailers in other states, and it may be possible that we and/or partners may have been or may be named in similar cases in other states. We do not believe that we are liable under existing laws and regulations for any failure to collect sales or other taxes relating to internet sales and intend to vigorously defend ourselves in this matter. However, we may incur substantial expenses in defending against this claim. In the event of a determination adverse to us, we may incur substantial monetary liability, and be required to change our business practices, either of which could have a material adverse effect on our business, financial position or results of operations.

We are subject to the same federal, state and local laws as other companies conducting e-commerce businesses. Due to the increasing growth and popularity of the Internet and e-commerce, many laws and regulations relating to these businesses, particularly the Internet, are proposed and considered at the federal, state and local levels. These laws and regulations could cover issues such as user privacy, freedom of expression, pricing, fraud, quality of products and services, taxation, advertising, intellectual property rights and information security. Applicability of existing laws governing issues such as property ownership, copyrights and other intellectual property issues, taxation, libel, obscenity and personal privacy could also harm our business. For example, United States and foreign laws regulate our ability to use customer information and to develop, buy and sell mailing lists. Many of these laws may not contemplate or address the unique issues raised by the Internet or e-commerce. Some laws that do contemplate or address those unique issues, such as the Digital Millennium Copyright Act and the CAN-SPAM Act of 2003, are only beginning to be interpreted by the courts and their applicability and reach are therefore uncertain. These current and future laws and regulations could reduce our ability to operate efficiently.

Laws or regulations relating to user information and online privacy may adversely affect the growth of our Internet business or our marketing efforts.

We are subject to increasing regulation at the federal and state levels relating to privacy and the use of personal user information. Several states have proposed legislation that would limit the uses of personal user information online or require collectors of information to establish privacy policies. The Federal Trade Commission has adopted regulations regarding the collection and use of personal identifying information obtained from children under 13. In addition, bills may be introduced in Congress that would extend online privacy protections to adults. Laws and regulations of this kind may include requirements that we establish procedures to disclose and notify users of privacy and security policies, obtain consent from users for collection and use of information, or provide users with the ability to access, correct and delete personal information stored by us. Even in the absence of those regulations, the Federal Trade Commission has settled several proceedings resulting in consent decrees in which Internet companies have been required to establish programs regarding the manner in which personal information is collected from users and provided to third parties. We could become a party to a similar enforcement proceeding. These regulatory and enforcement efforts could also harm our ability to collect demographic and personal information from users, which could be costly or adversely affect our marketing efforts.

We have never paid dividends on our common stock and do not anticipate paying dividends in the foreseeable future.

We have never paid cash dividends on our common stock and do not anticipate that any cash dividends will be declared or paid in the foreseeable future. As a result, holders of our common stock will not receive a return, if any, on their investment unless they sell their shares of our common stock.

As of August 2, 2004, Michael G. Rubin, our Chairman, Co-President and Chief Executive Officer, beneficially owned 19.0%, funds affiliated with SOFTBANK Holdings Inc., or SOFTBANK, beneficially owned 21.1% and Interactive Technology Holdings, LLC, or ITH, a joint venture company of Comcast Corporation and QVC, Inc., beneficially owned 26.9% of our outstanding common stock, including currently exercisable warrants and options to purchase common stock. Should they decide to act together, any two of Mr. Rubin, SOFTBANK and ITH would be in a position to exercise effective control, and all three would be in a position to exercise complete control, over most matters requiring stockholder approval, including the election or removal of directors, approval of significant corporate transactions and the ability generally to direct our affairs. Furthermore, the stock purchase agreements pursuant to which SOFTBANK and ITH acquired their shares of our common stock provide that SOFTBANK and ITH each have the right to designate up to two members of our board of directors. This concentration of ownership and SOFTBANK’s and ITH’s right to designate members to our board of directors may have the effect of delaying or preventing a change in control of us, including transactions in which stockholders might otherwise receive a premium over current market prices for their shares.

It may be difficult for a third-party to acquire us and this could depress our stock price.

Pursuant to our amended and restated certificate of incorporation, we have authorized a class of 5,000,000 shares of preferred stock, which our board of directors may issue with terms, rights, preferences and designations as the board may determine and without any vote of the stockholders, unless otherwise required by law. Issuing the preferred stock, depending upon the terms, rights, preferences and designations set by our board, may delay, deter or prevent a change in control of us. In addition, issuing additional shares of common stock could result in dilution of the voting power of the current holders of our common stock. Moreover, “anti-takeover” provisions of Delaware law may restrict the ability of the stockholders to approve a merger or business combination or obtain control of us. As many investors consider a change of control as a desirable path to liquidity, delaying or preventing a change in control of our company may reduce the number of investors interested in our common stock, which could depress our stock price.

Pursuant to our amended and restated certificate of incorporation and under Delaware law, our directors are not liable to us or our stockholders for monetary damages for breach of fiduciary duty, except for liability for breach of a director’s duty of loyalty, acts or omissions by a director not in good faith or which involve intentional misconduct or a knowing violation of law, dividend payments or stock repurchases that are unlawful under Delaware law or any transaction in which a director has derived an improper personal benefit. In addition, we have entered into indemnification agreements with each of our directors. These agreements, among other things, require us to indemnify each director for certain expenses including attorneys’ fees, judgments, fines and settlement amounts incurred by any such person in any action or proceeding, including any action by us or in our right, arising out of the person’s services as one of our directors. Our directors are not currently subject to legal action that would require us to indemnify them; however, if any such actions were brought, the costs associated with such actions could be harmful to our business.

There have been no significant changes in market risk for the quarter ended July 3, 2004. See the information set forth in Part II, Item 7A of the Company’s Annual Report on Form 10-K for the fiscal year ended January 3, 2004 filed with the Securities and Exchange Commission on March 18, 2004, as amended May 3, 2004.

(a) Evaluation of Disclosure Controls and Procedures. Based on the evaluation of our disclosure controls and procedures (as defined in Securities Exchange Act Rules 13a-15(e) or 15d-15(e)), our Chief Executive Officer and our Chief Financial Officer have concluded as of the end of the period covered by this Quarterly Report on Form 10-Q, that our disclosure controls and procedures were effective.

(b) Changes in Internal Controls. During the most recently completed fiscal quarter, there were no changes in our internal control over financial reporting that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

We are involved in various litigation incidental to our current and discontinued businesses, including alleged infringement of intellectual property rights of third parties, contractual claims and claims relating to the manner in which goods are sold through our e-commerce platform.

We do not believe, based on current knowledge, that any of the foregoing claims are likely to have a material adverse effect on our business, financial position or results of operations. However, we may incur substantial expenses and devote substantial time to defend third-party claims whether or not such claims are meritorious. In the event of a determination adverse to us, we may incur substantial monetary liability, and may be required to implement expensive changes in our business practices or enter into costly royalty or licensing agreements. Any of these could have a material adverse effect on our business, financial position or results of operations.

ITEM 2. CHANGES IN SECURITIES, USE OF PROCEEDS AND ISSUER PURCHASES OF EQUITY SECURITIES.

During the fiscal quarter ended July 3, 2004, we filed or furnished to the Securities and Exchange Commission:

Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this Report to be signed on its behalf by the undersigned, hereunto duly authorized.


GSI COMMERCE, INC.

By:		/s/ MICHAEL G. RUBIN
		Michael G. Rubin Chairman, Co-President & Chief Executive Officer (principal executive officer)

By:		/s/ JORDAN M. COPLAND
		Jordan M. Copland Executive Vice President & Chief Financial Officer (principal financial officer & principal accounting officer)


Delaware		04-2958132
(State or other jurisdiction of incorporation or organization)		(I.R.S. Employer Identification Number)

1075 First Avenue, King of Prussia, PA		19406
(Address of principal executive offices)		(Zip Code)


Common Stock, $.01 par value		41,039,535
(Title of each class)		(Number of Shares)


		Page
PART I—FINANCIAL INFORMATION

Item 1.	Financial Statements:
	Condensed Consolidated Balance Sheets as of January 3, 2004 and July 3, 2004 (Unaudited)	1
	Condensed Consolidated Statements of Operations for the three-and six-month periods ended June 28, 2003 and July 3, 2004 (Unaudited)	2
	Condensed Consolidated Statements of Cash Flows for the six-month periods ended June 28, 2003 and July 3, 2004 (Unaudited)	3
	Notes to Condensed Consolidated Financial Statements (Unaudited)	4
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	14
Item 3.	Quantitative and Qualitative Disclosures About Market Risk	31
Item 4.	Controls and Procedures	31

PART II—OTHER INFORMATION

Item 1.	Legal Proceedings	32
Item 2.	Changes in Securities, Use of Proceeds and Issuer Purchases of Equity Securities	32
Item 3.	Unregistered Sales of Equity Securities and Use of Proceeds	32
Item 4.	Defaults Upon Senior Securities	33
Item 5.	Submission of Matters to a Vote of Security Holders	33
Item 6.	Other Information	33
Item 7.	Exhibits and Reports on Form 8-K	33

SIGNATURES		34


	January 3, 2004			July 3, 2004
ASSETS
Current assets:
Cash and cash equivalents	$	57,558		$	32,975
Marketable securities		11,912			15,268
Accounts receivable, net of allowance of $709 and $718, respectively		4,898			7,283
Inventory		22,910			22,031
Current portion – notes receivable		1,377			900
Prepaid expenses and other current assets		1,848			1,502

Total current assets		100,503			79,959
Property and equipment, net		44,840			63,269
Goodwill, net		13,453			13,453
Notes receivable		2,356			1,293
Other equity investments		2,159			2,847
Other assets, net of accumulated amortization of $2,644 and $3,352, respectively		12,272			11,745

Total assets	$	175,583		$	172,566

LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
Accounts payable	$	27,677		$	22,215
Accrued expenses and other		22,538			21,344
Deferred revenue		14,998			11,769
Current portion – note payable		—			150

Total current liabilities		65,213			55,478
Note payable		—			12,850
Mandatorily redeemable preferred stock, Series A, $0.01 par value, 10,000 shares authorized; 0 shares issued and outstanding as of January 3, 2004 and July 3, 2004, respectively		—			—
Commitments and contingencies
Stockholders’ equity:
Preferred stock, $0.01 par value, 4,990,000 shares authorized; 0 shares issued and outstanding as of January 3, 2004 and July 3, 2004, respectively		—			—
Common stock, $0.01 par value, 90,000,000 shares authorized; 40,781,036 and 41,011,620 shares issued as of January 3, 2004 and July 3, 2004, respectively; 40,779,826 and 41,010,410 shares outstanding as of January 3, 2004 and July 3, 2004, respectively		408			410
Additional paid in capital		287,571			288,708
Accumulated other comprehensive loss		—			(97	)
Accumulated deficit		(177,609	)		(184,783	)

		110,370			104,238
Less: Treasury stock, at par		—			—

Total stockholders’ equity		110,370			104,238

Total liabilities and stockholders’ equity	$	175,583		$	172,566


	Three Months Ended						Six Months Ended
	June 28, 2003			July 3, 2004			June 28, 2003			July 3, 2004
Revenues:
Net revenues from product sales	$	45,722		$	53,131		$	89,895		$	110,009
Service fee revenues		4,626			11,558			9,332			20,948

Net revenues		50,348			64,689			99,227			130,957
Cost of revenues from product sales		33,307			39,564			65,160			81,072

Gross profit		17,041			25,125			34,067			49,885

Operating expenses:
Sales and marketing, exclusive of $279, $195, $508 and $689 reported below as stock-based compensation, respectively		11,095			16,787			24,219			34,236
Product development, exclusive of $0, $(47), $0 and $2 reported below as stock-based compensation, respectively		3,418			4,498			7,117			8,981
General and administrative, exclusive of $125, $5, $184 and $89 reported below as stock-based compensation, respectively		3,457			4,375			6,538			8,295
Stock-based compensation		404			153			692			780
Depreciation and amortization		2,734			2,646			5,432			5,245

Total operating expenses		21,108			28,459			43,998			57,537

Other (income) expense:
Interest expense		—			54			—			54
Interest income		(290	)		(242	)		(671	)		(532	)

Total other (income) expense		(290	)		(188	)		(671	)		(478	)

Net loss	$	(3,777	)	$	(3,146	)	$	(9,260	)	$	(7,174	)

Losses per share—basic and diluted:
Net loss	$	(0.10	)	$	(0.08	)	$	(0.24	)	$	(0.18	)

Weighted average shares outstanding—basic and diluted		38,838			40,991			38,811			40,930

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	January 3, 2004
	Amortized Cost		Gross Unrealized Gains		Gross Unrealized Losses⁽¹⁾			Estimated Fair Value
	(in thousands)
Corporate bonds	$	2,908	$	7	$	(10	)	$	2,905
U.S. government agency securities		9,004		12		(9	)		9,007

	$	11,912	$	19	$	(19	)	$	11,912


	July 3, 2004
	Amortized Cost		Gross Unrealized Gains		Gross Unrealized Losses ⁽¹⁾			Estimated Fair Value
	(in thousands)
Corporate bonds	$	5,563	$	—	$	(49	)	$	5,514
U.S. government agency securities		9,802		3		(51	)		9,754

	$	15,365	$	3	$	(100	)	$	15,268


Year 1	$	150
Year 2		146
Year 3		157
Year 4		165
Year 5		178
Thereafter		12,204

	$	13,000


	Common Stock			Additional Paid in Capital			Accumulated Deficit			Comprehensive Loss			Accumulated Other Comprehensive Income (Loss)			Treasury Stock				Total
	Shares	Dollars		Additional Paid in Capital			Accumulated Deficit			Comprehensive Loss						Shares	Dollars			Total
	(in thousands)
Consolidated balance at March 29, 2003	38,849	$	389	$	285,692		$	(171,030	)				$	49		74	$	(1	)	$	115,099
Net loss								(3,777	)	$	(3,777	)									(3,777	)
Net unrealized losses on available-for-sale securities											(14	)		(14	)						(14	)

Comprehensive loss										$	(3,791	)

Issuance of options to purchase common stock in exchange for services					131																131
Issuance of common stock upon exercise of options	26		—		100																100
Issuance of common stock under Employee Stock Purchase Plan	84		1		210																211

Consolidated balance at June 28, 2003	38,959	$	390	$	286,133		$	(174,807	)				$	35		74	$	(1	)	$	111,750

Consolidated balance at April 3, 2004	40,974	$	410	$	288,739		$	(181,637	)				$	(25	)	1	$	—		$	107,487
Net loss								(3,146	)	$	(3,146	)									(3,146	)
Net unrealized losses on available-for-sale securities											(72	)		(72	)						(72	)

Comprehensive loss										$	(3,218	)

Issuance of options to purchase common stock in exchange for services					(179	)															(179	)
Issuance of common stock upon exercise of options	38		—		148																148

Consolidated balance at July 3, 2004	41,012	$	410	$	288,708		$	(184,783	)				$	(97	)	1	$	—		$	104,238


	Three Months Ended
	June 28, 2003				July 3, 2004
	Number of Shares		Weighted Average Exercise Price		Number of Shares		Weighted Average Exercise Price
	(in thousands)				(in thousands)
Outstanding, beginning of period	5,327		$	7.78	6,401		$	8.28
Granted	33			2.34	385			9.40
Exercised	(26	)		3.92	(37	)		4.00
Cancelled	(35	)		7.18	(227	)		8.97

Outstanding, end of period	5,299			7.77	6,522			8.35

Exercisable, end of period	3,235			8.10	4,008			8.00


	Outstanding				Exercisable
Range of Exercise Prices	Number Outstanding	Weighted Average Remaining Contractual Life In Years	Weighted Average Exercise Price		Number Exercisable	Weighted Average Exercise Price
	(in thousands)				(in thousands)
$ 1.00 – $ 5.56	2,651	6.32	$	4.46	1,965	$	4.67
$ 5.69 – $10.00	3,556	5.45		8.66	1,845		8.04
$10.60 – $24.69	1,122	6.11		15.39	805		16.09
$33.33 – $50.00	9	0.19		36.82	9		36.82

$ 1.00 – $50.00	7,338	5.87		8.28	4,624		8.18


	Three Months Ended
Assumption	June 28, 2003		July 3, 2004
Dividend yield	None		None
Expected volatility	105.00	%	96.00	%
Average risk free interest rate	1.87	%	3.35	%
Average expected lives	3.87 years		3.30 years


Assumption	Three Months Ended July 3, 2004
Dividend yield	None
Expected volatility	100.00	%
Average risk free interest rate	3.93	%
Average expected life	5.00 years


	Three Months Ended						Six Months Ended
	June 28, 2003			July 3, 2004			June 28, 2003			July 3, 2004
	(in thousands)						(in thousands)
Net loss	$	(3,777	)	$	(3,146	)	$	(9,260	)	$	(7,174	)

Weighted average shares outstanding—basic and diluted		38,838			40,991			38,811			40,930

Outstanding common stock options having no dilutive effect		5,299			6,522			5,299			6,522

Outstanding common stock warrants having no dilutive effect		5,319			816			5,319			816


	Second Qtr Fiscal 2003					Second Qtr Fiscal 2004					Second Qtr Fiscal 2004 vs Second Qtr Fiscal 2003
	$			%		$			%		$ Change			% Change
	(dollars in millions)
Net revenues from product sales	$	45.7		90.9	%	$	53.1		82.1	%	$	7.4		16.2	%
Service fee revenues		4.6		9.1	%		11.6		17.9	%		7.0		152.2	%

Net revenues		50.3		100.0	%		64.7		100.0	%		14.4		28.6	%
Cost of revenues from product sales		33.3		66.2	%		39.6		61.2	%		6.3		18.9	%

Gross profit		17.0		33.8	%		25.1		38.8	%		8.1		47.6	%
Sales and marketing expenses		11.1		22.1	%		16.8		26.0	%		5.7		51.4	%
Product development expenses		3.4		6.8	%		4.5		7.0	%		1.1		32.4	%
General and administrative expenses		3.5		7.0	%		4.4		6.8	%		0.9		25.7	%
Stock-based compensation expense		0.4		0.8	%		0.2		0.3	%		(0.2	)	-50.0	%
Depreciation and amortization expenses		2.7		5.4	%		2.6		4.0	%		(0.1	)	-3.7	%
Interest expense		—		0.0	%		0.1		0.2	%		0.1		0.0	%
Interest income		(0.3	)	-0.6	%		(0.2	)	-0.3	%		(0.1	)	-33.3	%
Net loss		(3.8	)	-7.6	%		(3.1	)	-4.8	%		0.7		18.4	%


	First Six Months Fiscal 2003					First Six Months Fiscal 2004					First Six Months Fiscal 2004 vs First Six Months Fiscal 2003
	$			%		$			%		$ Change			% Change
	(dollars in millions)
Net revenues from product sales	$	89.9		90.6	%	$	110.0		84.0	%	$	20.1		22.4	%
Service fee revenues		9.3		9.4	%		20.9		16.0	%		11.6		124.7	%

Net revenues		99.2		100.0	%		131.0		100.0	%		31.8		32.1	%
Cost of revenues from product sales		65.2		65.7	%		81.1		61.9	%		15.9		24.4	%

Gross profit		34.1		34.4	%		49.9		38.1	%		15.8		46.3	%
Sales and marketing expenses		24.2		24.4	%		34.2		26.1	%		10.0		41.3	%
Product development expenses		7.1		7.2	%		9.0		6.9	%		1.9		26.8	%
General and administrative expenses		6.5		6.6	%		8.3		6.3	%		1.8		27.7	%
Stock-based compensation expense		0.7		0.7	%		0.8		0.6	%		0.1		14.3	%
Depreciation and amortization expenses		5.4		5.4	%		5.2		4.0	%		(0.2	)	-3.7	%
Interest expense		—		0.0	%		0.1		0.1	%		0.1		0.0	%
Interest income		(0.7	)	-0.7	%		(0.5	)	-0.4	%		(0.2	)	-28.6	%
Net loss		(9.3	)	-9.4	%		(7.2	)	-5.5	%		2.1		22.6	%


					Second Qtr Fiscal 2004 vs Second Qtr Fiscal 2003
	Second Qtr Fiscal 2003		Second Qtr Fiscal 2004		$ Change		% Change
	(dollars in thousands)
Net revenues from product sales:
Category:
Sporting goods	$	27,011	$	33,586	$	6,575	24	%
Other		18,711		19,545		834	4	%

Total net revenues from product sales	$	45,722	$	53,131	$	7,409	16	%


					First Six Months Fiscal 2004 vs First Six Months Fiscal 2003
	First Six Months Fiscal 2003		First Six Months Fiscal 2004		$ Change		% Change
	(dollars in thousands)
Net revenues from product sales:
Category:
Sporting goods	$	51,418	$	67,124	$	15,706	31	%
Other		38,477		42,885		4,408	11	%

Total net revenues from product sales	$	89,895	$	110,009	$	20,114	22	%


10.1		First Amendment to Contract of Sale, dated April 30, 2004, by and between Brandywine Operating Partnership, L.P. and 935 KOP Associates, LLC

10.2		Second Amendment to Contract of Sale, dated May 24, 2004, by and between Brandywine Operating Partnership, L.P. and 935 KOP Associates, LLC

10.3		Option Agreement, dated June 9, 2004, by and between Brandywine Operating Partnership, L.P. and 935 KOP Associates, LLC

10.4	*	Amended and Restated E-Commerce Agreement between GSI Commerce Solutions, Inc. and palmOne, Inc. dated May 10, 2004

10.5		Promissory Note from 935 HQ Associates, LLC to CIBC Inc. dated June 9, 2004

10.6		Mortgage, Assignment of Leases and Rents and Security Agreement from 935 HQ Associates, LLC in favor of CIBC Inc. dated as of June 9, 2004

31.1		Certification of Chief Executive Officer pursuant to Rule 13a—14(a) under the Securities Exchange Act of 1934

31.2		Certification of Chief Financial Officer pursuant to Rule 13a—14(a) under the Securities Exchange Act of 1934

32.1		Certification of Chief Executive Officer and Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002