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SFLY > SEC Filings for SFLY > Form 10-Q on 5-Nov-2013All Recent SEC Filings

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Form 10-Q for SHUTTERFLY INC


5-Nov-2013

Quarterly Report


ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.

CAUTIONARY NOTE REGARDING FORWARD-LOOKING STATEMENTS

This report, including the following Management's Discussion and Analysis of Financial Condition and Results of Operations, contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and
Section 21E of the Securities Exchange Act of 1934 that are based upon our current expectations. These forward-looking statements include statements related to our business strategy and plans, expectations regarding the seasonality and growth of our business, the impact on us of general economic conditions, trends in key metrics such as total number of customers, total number of orders, and average order value, our capital expenditures for 2013, the sufficiency of our cash and cash equivalents and cash generated from operations for the next 12 months, our operating expenses remaining a consistent percentage of our net revenues, anticipated benefits from mergers and acquisitions and our plans to integrate acquired technologies and manufacturing capabilities, effective tax rates, our outstanding convertible senior notes, as well as other statements regarding our future operations, financial condition and prospects and business strategies. In some cases, you can identify forward-looking statements by terminology such as "believe," "anticipate," "expect," "estimate," "intend," "continue," "should," "would," "could," "will," or "may," or the negative of these terms or other comparable terminology. Forward-looking statements involve risks and uncertainties. Our actual results and the timing of events could differ materially from those anticipated in our forward-looking statements as a result of many factors, including but not limited to, economic downturns and the general state of the economy; changes in consumer discretionary spending as a result of the macroeconomic environment; competition, which could lead to pricing pressure; our ability to expand our customer base and increase sales to existing customers and meet production requirements; our ability to retain and hire necessary employees, including seasonal personnel, and appropriately staff our operations; the impact of seasonality on our business; our ability to develop technology on a timely basis, as well as consumer acceptance of, new products, features and services; our ability to successfully acquire businesses and technologies and to successfully integrate and operate these acquired businesses and technologies; our ability to achieve expected benefits of our partnerships; our ability to develop additional adjacent lines of business; unforeseen changes in expense levels; and our ability to timely upgrade and develop our infrastructure and facilities and the other risks set forth below under "Risk Factors" in Part II, Item 1A of this report. Given these risks and uncertainties, readers are cautioned not to place undue reliance on such forward-looking statements. We assume no obligation to update any of the forward-looking statements after the date of this report or to compare these forward-looking statements to actual results.

Overview

We are the leading manufacturer and digital retailer of high-quality personalized products and services offered through a family of lifestyle brands. Our vision is to make the world a better place by helping people share life's joy. Our mission is to build an unrivaled service that enables deeper, more personal relationships between our customers and those who matter most in their lives. Our primary focus is on helping consumers manage their memories through the powerful medium of photography. We provide a full range of personalized photo-based products and services that make it easy, convenient and fun for consumers to upload, edit, enhance, organize, find, share, create, print, and preserve their memories in a creative and thoughtful manner.

We are building seven trusted premium lifestyle brands: Shutterfly, Tiny Prints, Wedding Paper Divas, Treat, ThisLife, MyPublisher and BorrowLenses. We have operated the Shutterfly.com brand since inception in 1999. In 2011, we acquired Tiny Prints, Inc. a privately-held company based in Sunnyvale, California that operated tinyprints.com and weddingpaperdivas.com, two growing ecommerce brands primarily offering stylish cards, invitations and personalized stationery. On April 16, 2012, we launched Treat.com, a destination that enables users to easily personalize and send unique greeting cards. Our Treat launch signifies our focused expansion into the one-to-one U.S. greeting card market, to complement our existing one-to-many card business. In May 2012, we acquired the customer accounts and images of Kodak Gallery's online photo service through a bankruptcy court supervised auction. In July 2012, we began the process to transfer the more than five billion Kodak Gallery customer photos onto the Shutterfly technology platform, which was completed in September 2012.

On May 25, 2012, we acquired Photoccino Ltd., a privately-held company based in Haifa, Israel, which has developed innovative technologies for photo ranking, analysis and organization that allows users to more efficiently organize and select the best photos from their ever-increasing archives so they can quickly and easily create photo books, calendars, cards, and photo gifts. Photoccino's technology applies proprietary algorithms to analyze and evaluate the quality and content of photos, ranks them, and automatically creates photo products using the customer's best images. During the fourth quarter of 2012, we began to integrate the Photoccino technology by offering smart product creation capabilities to a select set of customers and have continued to integrate further the Photoccino technology into our products and services during 2013.


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On September 14, 2012, we acquired Penguin Digital, Inc., a mobile application development company that has an iPhone application that allows users to access their photos from iPhones or their Facebook or Instagram accounts and create customized products and gifts from their mobile devices. We subsequently introduced our new Shutterfly iPhone Photo App which combines storage, viewing and photo gift creation right from one's phone.

On December 28, 2012, we acquired ThisLife.com, Inc. ("ThisLife") a cloud-based service provider for protecting, organizing, storing and sharing photos and videos which will strengthen our photo and video storage and sharing capabilities, as well as the ability to intelligently organize across devices and mobile platforms and enable the more efficient creation of products across the web and on mobile devices. We recently launched the beta version of our ThisLife service and we continue to expect to integrate this technology into the products and services that our Shutterfly brand offers.

On April 29, 2013, we acquired MyPublisher, Inc. ("MyPublisher") a pioneer in the photo book industry and creator of easy-to-use photo book-making software. We expect to combine MyPublisher's photo book technology and highly specialized manufacturing capabilities with our platform to expand our customer base and to enable us to further differentiate our product and service offerings.

And on October 24, 2013, the Company acquired BorrowLenses, a premier online marketplace for photographic and video equipment rentals. We expect BorrowLenses to diversify the Company's revenue streams and provide a presence in the expanding sharing economy. Operating results of BorrowLenses will be included in the Company's results for the fourth quarter of 2013.

We generate the majority of our revenues by producing and selling professionally-bound photo books, greeting and stationery cards, personalized calendars, other photo-based merchandise and high-quality prints ranging in size from wallet-sized to jumbo-sized 20x30 enlargements. We manufacture most of these items in our Fort Mill, South Carolina, Phoenix, Arizona and Elmsford, New York production facilities. By controlling the production process in our own production facilities, we are able to produce high-quality products, innovate rapidly, maintain a favorable cost structure and ensure timely shipment to customers, even during peak periods of demand. Additionally, we sell a variety of photo-based merchandise that is currently manufactured for us by third parties, such as calendars, iPhone cases, mugs, canvas prints, mouse pads, magnets, and puzzles. We generate substantially all of our revenue from sales originating in the United States and our sales cycle has historically been highly seasonal as we generate more than 50% of our total net revenues during our fiscal fourth quarter.

Our high-quality products and services and the compelling online experience we create for our customers, combined with our focus on continuous innovation, have allowed us to establish premium brands. We realize the benefits of premium brands through high customer loyalty, low customer acquisition costs and premium pricing.

Our customers are a central part of our business model. They generate most of the content on our service by uploading their photos and storing their memories. In addition, they share their photos electronically with their friends and families, extending and endorsing our brand and creating a sense of community. Finally, by giving our branded products to colleagues, friends and loved ones throughout the year, customers reinforce our brands. Through these various activities, our customers create a viral network of new users and customers.

In addition to driving lower customer acquisition costs through viral marketing, our customers provide input on new features, functionalities and products. Close, frequent customer interactions, coupled with significant investments in sophisticated integrated marketing programs, enable us to fine-tune and tailor our promotions and website presentation to specific customer segments. Consequently, customers are presented with a highly personalized shopping experience, which helps foster a unique and deep relationship with our brands.

Our operations and financial performance depend on general economic conditions in the United States, consumer sentiment and the levels of consumer discretionary spending. We closely monitor these economic measures as their trends are indicators of the health of the overall economy and are some of the key external factors that impact our business.

Basis of Presentation

Net Revenues. Our net revenues are comprised of sales generated from our Consumer and Enterprise categories.

Consumer. Our Consumer revenues include sales from all of our brands and are derived from the sale of photo-based products, such as photo books, stationery and greeting cards, other photo-based merchandise, photo prints, and the related shipping revenues. Included in our photo-based merchandise are items such as mugs, iPhone cases, mouse pads, desktop plaques and puzzles. Photo prints consist of wallet, 4x6, 5x7, 8x10, and large format sizes. Revenue from advertising displayed on our websites is also included in Consumer revenues.


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Enterprise. Our Enterprise revenues are primarily from variable, four-color direct marketing collateral manufactured and fulfilled for business customers. We continue to focus our efforts in expanding our presence in this market.

Our business is subject to seasonal fluctuations. In particular, we generate a substantial portion of our revenues during the holiday season in the fourth quarter. We also typically experience increases in net revenues during other shopping-related seasonal events, such as Easter, Mother's Day, Father's Day, and Halloween. We generally experience lower net revenues during the first, second and third calendar quarters and have incurred and may continue to incur losses in these quarters. Due to the relatively short lead time required to fulfill product orders, usually one to three business days, order backlog is not material to our business.

To further understand net revenue trends in our Consumer category, we monitor several key metrics including, total customers, total number of orders, and average order value. These metrics represent the aggregate of all customers and orders across all our Consumer brands.

Total Customers. We closely monitor total customers as a key indicator of demand. Total customers represents the number of transacting customers in a given period. We seek to expand our customer base by empowering our existing customers with sharing and collaboration services (such as Shutterfly Share Sites), and by conducting integrated marketing and advertising programs. We also acquire new customers through customer list acquisitions. Total customers have increased on an annual basis for each year since inception and we expect this trend to continue.

Total Number of Orders. We closely monitor total number of orders as a leading indicator of net revenue trends. We recognize net revenues associated with an order when the products have been shipped and all other revenue recognition criteria have been met. Orders are typically processed and shipped in approximately two business days after a customer places an order. Total number of orders has increased on an annual basis for each year since 2000, and we anticipate this trend to continue in the future.

Average Order Value. Average order value is Consumer net revenues for a given period divided by the total number of customer orders recorded during that same period. Average order value is impacted by product sales mix and pricing and promotional strategies, including our promotions and competitor promotional activity. As a result, we expect that our average order values may fluctuate on an annual basis.

We believe the analysis of these metrics and the financial measures described below under "Non-GAAP Financial Measures" provides us with important information on our overall net revenue trends and operating results. Fluctuations in these metrics are not unusual and no single factor is determinative of our net revenues and operating results.

Cost of Net Revenues. Cost of net revenues consists primarily of direct materials (the majority of which consists of paper, ink, and photo book covers), payroll and related expenses for direct labor, shipping charges, packaging supplies, distribution and fulfillment activities, rent for production facilities and equipment, depreciation of production equipment, and third-party costs for photo-based merchandise. Cost of net revenues also includes payroll and related expenses for personnel and third parties engaged in customer service, any third-party software or patents licensed, as well as the amortization of acquired developed technology, capitalized website and software development costs, and patent royalties. Cost of net revenues also includes certain costs associated with facility closures and restructuring.

Operating Expenses. Operating expenses consist of technology and development, sales and marketing, and general and administrative expenses. We anticipate that each of the following categories of operating expenses will increase in absolute dollar amounts, but remain relatively consistent as a percentage of net revenues.

Technology and development expense consists primarily of personnel and related costs for employees and contractors engaged in the development and ongoing maintenance of our websites, infrastructure and software. These expenses include depreciation of the computer and network hardware used to run our websites and store the customer data, as well as amortization of purchased software. Technology and development expense also includes co-location, power and bandwidth costs.

Sales and marketing expense consists of costs incurred for marketing programs, and personnel and related expenses for our customer acquisition, product marketing, business development, and public relations activities. Our marketing efforts consist of various online and offline media programs, such as e-mail and direct mail promotions, the purchase of keyword search terms and various strategic alliances. We depend on these efforts to attract customers to our service.

General and administrative expense includes general corporate costs, including rent for our corporate offices, insurance, depreciation on information technology equipment, and legal and accounting fees. Transaction costs are also included in general


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and administrative expense. In addition, general and administrative expense includes personnel expenses of employees involved in executive, finance, accounting, human resources, information technology and legal roles. Third-party payment processor and credit card fees are also included in general and administrative expense and have historically fluctuated based on revenues during the period. All of the payments we have received from our intellectual property license agreements have been included as an offset to general and administrative expense.

Interest Expense. Interest expense consists of interest on our convertible senior notes, costs associated with our five-year syndicated credit facility that became effective in November 2011, as amended in May 2013, and costs associated with our capital leases and build-to-suit lease financing obligations.

Interest and Other Income, Net. Interest and other income, net primarily consists of the interest earned on our cash and investment accounts.

Income Taxes. We account for income taxes under the liability method. Under this method, deferred tax assets and liabilities are determined based on the difference between the financial statement and tax basis of assets and liabilities. We are subject to taxation in the United States and Israel.

Critical Accounting Policies and Estimates

The discussion and analysis of our financial condition and results of operations are based upon our unaudited condensed consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses. On an on-going basis, we evaluate our critical accounting policies and estimates. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. Our critical accounting policies and estimates are discussed in our Annual Report on Form 10-K for the fiscal year ended December 31, 2012.

Results of Operations

The following table presents the components of our income statement as a
percentage of net revenues:

                                 Three Months Ended       Nine Months Ended
                                   September 30,            September 30,
                                  2013         2012        2013         2012
Net revenues                     100  %        100  %     100  %        100  %
Cost of net revenues              58  %         56  %      55  %         54  %
Gross profit                      42  %         44  %      45  %         46  %
Operating expenses:
Technology and development        22  %         22  %      21  %         21  %
Sales and marketing               30  %         30  %      29  %         30  %
General and administrative        18  %         16  %      17  %         16  %
Total operating expenses          70  %         68  %      67  %         67  %
Loss from operations             (28 )%        (24 )%     (22 )%        (21 )%
Interest expense                  (3 )%          -  %      (2 )%          -  %
Interest and other income, net     -  %          -  %       -  %          -  %
Loss before income taxes         (31 )%        (24 )%     (24 )%        (21 )%
Benefit from income taxes         23  %         13  %      14  %         11  %
Net loss                          (8 )%        (11 )%     (10 )%        (10 )%


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Comparison of the Three Month Periods Ended September 30, 2013 and 2012

                                       Three Months Ended September 30,
                                2013                2012      $ Change    % Change
                                                (in thousands)
Net revenues
Consumer                   $    112,695          $ 90,378    $  22,317       25 %
Enterprise                        9,990             8,158        1,832       22 %
Total net revenues              122,685            98,536       24,149       25 %
Cost of net revenues             71,308            55,129       16,179       29 %
Gross profit               $     51,377          $ 43,407    $   7,970       18 %
Percentage of net revenues           42 %              44 %          -        -

Net revenues increased $24.1 million, or 25%, for the three months ended September 30, 2013 as compared to the same period in 2012. Consumer net revenues increased $22.3 million, or 25%, in the three months ended September 30, 2013 compared to the same period in 2012. The increase in Consumer net revenues is primarily a result of increased sales of greeting and stationery cards, photo books, including net revenues from the recently acquired MyPublisher brand, and other photo-based merchandise. Enterprise revenues increased $1.8 million, or 22%, in the three months ended September 30, 2013 compared to the same period in 2012 due to an increase in order volume from both existing and new customers.

Consumer net revenue increases were also the result of year-over-year increases in each of our key metrics as outlined below. Improvements in average order value reflect the strength of our customer base and continued benefit from pricing and promotional initiatives.

                                 Three Months Ended September 30,
                            2013             2012      $ Change      % Change
                                (in thousands, except AOV amounts)
Customers                2,381               2,247           134         6 %
Orders                   3,877               3,606           271         8 %
Average order value $    29.07             $ 25.06    $     4.01        16 %

Cost of net revenues increased $16.2 million, or 29%, for the three months ended September 30, 2013 as compared to the same period in 2012. As a percentage of net revenues, cost of net revenues increased to 58% in the three months ended September 30, 2013 from 56% in the same period in 2012, which decreased gross margin to 42% in the three months ended September 30, 2013 from 44% in the same period in 2012. Overall, the increase in cost of net revenues was primarily the result of the increased volume of shipped products. The decrease in gross margin was primarily driven by higher depreciation and amortization, equipment lease expense and increased customer service expenses related to our new Fort Mill, South Carolina manufacturing facility, as well as lower average selling prices for a subset of products; which was partially offset by lower material costs related to our increased scale and insourcing, lower shipping rates as well as a favorable shift in product mix.

                                      Three Months Ended September 30,
                               2013            2012       $ Change      % Change
                                               (in thousands)
Technology and development $   27,508       $ 21,538     $    5,970        28 %
Percentage of net revenues         22 %           22 %            -         -
Sales and marketing        $   36,774       $ 29,575     $    7,199        24 %
Percentage of net revenues         30 %           30 %            -         -
General and administrative $   21,717       $ 16,039     $    5,678        35 %
Percentage of net revenues         18 %           16 %            -         -

Our technology and development expense increased $6.0 million, or 28%, for the three months ended September 30, 2013, compared to the same period in 2012. As a percentage of net revenues, technology and development expense remained consistent at 22% for the three months ended September 30, 2013 and 2012. The overall increase was primarily due to an increase of $4.5


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million in personnel and related costs due to increased headcount. The increase in technology and development expense was also due to an increase of $1.3 million in depreciation expense, an increase to stock-based compensation of $1.1 million, and an increase of $0.4 million in professional fees. These factors were partially offset by a decrease of $0.8 million in facilities and office supplies and an increase of $0.7 million in website developmental costs capitalized in the current period compared to the same period in the prior year.

At September 30, 2013, headcount in technology and development increased by 34% compared to September 30, 2012, reflecting our strategic focus to increase the rate of innovation in our product and services offerings, to generate greater differentiation from our competitors, and improve our long-term operating efficiency. In the three months ended September 30, 2013, we capitalized $4.3 million in eligible salary and consultant costs, including $0.4 million of stock-based compensation associated with software developed or obtained for internal use, compared to $3.6 million capitalized in the three months ended September 30, 2012, which included $0.3 million of stock-based compensation.

Our sales and marketing expense increased $7.2 million, or 24%, in the three months ended September 30, 2013 compared to the same period in 2012. The increase in sales and marketing expense was primarily due to an increase of $3.2 million of stock-based compensation and an increase of $1.7 million in personnel and related costs associated with the expansion of our internal marketing team. The increase is also attributable to an increase of $1.5 million related to brand and performance marketing campaigns, an increase of $0.5 million in intangible asset amortization from acquisition related intangibles, and an increase of $0.3 million related to professional fees. As a percentage of net revenues, total sales and marketing expense remained consistent at 30% in the three months ended September 30, 2013 and 2012.

Our general and administrative expense increased $5.7 million, or 35%, in the three months ended September 30, 2013 as compared to the same period in 2012. As a percentage of net revenues, general and administrative expense increased to 18% in the three months ended September 30, 2013 from 16% in the three months ended September 30, 2012. The increase in general and administrative expense is primarily due to an increase in depreciation and amortization of $1.5 million primarily from acquisition related intangibles, an increase in stock-based compensation of $1.3 million and an increase in personnel related costs of $1.3 million as a result of increased headcount. The increase was also attributable to an increase in professional fees of $0.8 million, an increase in credit card fees of $0.5 million which was driven by the increase in Consumer net revenues as compared to the prior year, an increase in gain on asset disposition of $0.2 million, and an increase in facilities costs of $0.2 million. . . .

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