Shutterfly, Inc. Q3 2008 (Quarter End 9/30/2008) Earnings Call Transcript

Oct.30.08 | About: Shutterfly, Inc. (SFLY)

Shutter, Inc. (NASDAQ:SFLY)

Q3 2008 Earnings Call

October 29, 2008 5:00 pm ET

Executives

John A. Kaelle – Vice President - Finance

Jeffrey T. Housenbold – President & Chief Executive Officer

Mark J. Rubash – Chief Financial Officer

Analysts

Imran Khan – JP Morgan

Troy Mastin – William Blair & Company

Kristine Koerber – JMP Securities, LLC.

Youssef Squali – Jefferies & Co.

Derek Brown – Cantor Fitzgerald

Jim Friedland – Cowen & Company

Alan Gould – Natixis Bleichroeder, Inc.

Good day everyone and welcome to Shutterfly’s third quarter 2008 earnings conference call. Today’s call is being recorded. At this for opening remarks and introductions I would like to turn the call over to Mr. John Kaelle, Shutterfly’s Vice President of Finance.

John A. Kaelle

Good afternoon everyone and welcome to Shutterfly’s third quarter 2008 conference call. With us today are Jeff Housenbold, Chief Executive Officer of Shutterfly and Mark Rubash, Chief Financial Officer. The press release detailing our results is available on Shutterfly.com and an archived copy will be kept on our site. We have also released the visuals that we’ll use as throughout to the call.

Additionally, within a few hours we will release the recording of this call both in a streaming online format and through a downloadable podcast. You can access all this through the investor relations section of our website at Shutterfly.com. Before we begin I’d like to note that our discussion today will include forward-looking statements within the meaning of the Securities Act of 1933 and the Securities Exchange Act of 1934. These forward-looking statements include statements about our business outlook and strategy and statements about historical results that may suggest trends for our business.

For more information regarding these risks and uncertainties that could cause actual results to differ materially from those expressed or implied in these forward-looking statements as well as risks relating to our business in general, we refer you to the section entitled Risk Factors in the company’s latest quarterly report on Form 10-Q and its other filings with the SEC. I’d also like to note that any forward-looking statements made on this call reflect analysis as of today.

This presentation contains certain financial performance measures that are different from financial measures calculated in accordance with GAAP and may be different from calculations of measures made by other companies. A quantitative reconciliation of these non-GAAP financial measures to the most directly comparable GAAP financial measures is available in our Q3 2008 earnings press release which is posted on the investor relations section of our website at Shutterfly.com.

Now I’d like to turn the call over to Shutterfly’s CEO, Jeff Housenbold.

Jeffrey T. Housenbold

Welcome everyone. Our agenda today will start with a review of third quarter highlights, some comments about Q4 preparedness and then some remarks about how Shutterfly is managing through these tough economic times. Then I’ll turn the call over to Mark to review our financial performance in detail and provide guidance for Q4 and full year 2008 and then we’ll open up the call for Q&A.

As you listen to our remarks today I’d like you to keep in mind four key messages. First, I’m proud of the entire Shutterfly team as they delivered a very solid Q3 despite an increasingly tough macroeconomic environment. Q3 marked our 31st consecutive quarter of year-over-year revenue growth and we delivered a top line with better-than-expected gross and net margins.

While revenue growth continues to be dampened by the financial crisis and the macroeconomic recession, we are confident that our compelling suite of products and services and our continued innovation positions us well in these early and large markets for personal publishing and social expression.

Second, the entire company is focused on improving free cash flows in both the short and long term. Evidence of our execution can be seen in our year-to-date results. We are beginning to realize leverage in our business model and gross margins, operating margins and in capital expenditures; the latter arising from our strategic storage and manufacturing initiatives. These structural improvements will benefit us in the mid to long term. However, the rapid decline in consumer sentiment and spending will likely dampen some of the benefits in the short term.

Third, given the size of the market opportunity, the early penetration rates and our leadership position, we will continue to build for the future even during this economic slowdown. We will continue to strengthen our brand and franchise, introduce new products and services to delight our customers and increase their loyalty and evangelism of Shutterfly.

Our focus will remain on growing the personalized products and services components of the business where we lead the industry in terms of sales and innovation. We are also making appropriately sized investments in new businesses that leverage our manufacturing assets and our active customer base. Our primary focus will be on launching a successful commercial printing business and secondarily on incubating a sponsorship and advertising program. If successful, these initiatives have the potential to deliver new revenue streams, higher margins and increased free cash flow in 2009 and beyond.

Fourth, we are well positioned for the seasonally strong fourth quarter. This will be my fourth year of managing through this super busy season and Shutterfly is better prepared than ever before. We have innovative new products and services, ample manufacturing capacity and a well trained team that’s ready to take on the demands of the quarter.

With those key messages in mind I’ll provide a quick recap of our major activities during the third quarter. It was a very busy quarter especially from a personalized products and services standpoint. In preparation for Q4 we enhanced our existing products and services and added new products, formats, designs and layouts. Our customers have been very enthusiastic about our award winning photo books. However, we are constantly seeking their feedback to improve both the creation process and the physical product, to increase purchase frequency and ultimately to drive mass adoption.

Our research shows that there are three key areas of opportunity to increase sales of photo books: improve the ease of use, reduce the time to create and grow the awareness of photo books as a better way to tell your story than 4x6 prints. To that end we launched a number of improvements during Q3 that will extend our leading share of the photo book market.

These include Storyboard which enables our customers to build pages quicker, dynamic layouts that automatically update to fit the number and the orientation of the photos, two-row picture strip and a pictures tab within the creation path to make it easier to view and interact with photos, 69 new layouts across each of our four main book sizes and new holiday photo books with holiday icons and rich backgrounds for both Halloween and Christmas.

In addition to upgrading our photo book line, we extended our greeting card and our designer card lines. Specifically, we updated the shopping experience to help customers find the type of card and the design that is best for their needs. We did this through enhanced on site merchandising and our innovative holiday card finder which is an interactive tool that navigates users through the decision process.

We also added hundreds of new classic, fun and modern holiday designs from leading designers across our four formats which include 4x8 and 5x7 photo cards, 5x7 folded greeting cards and 5x7 flat designer cards. And we expanded our designer card collection to address addition use occasions including non-photo invitations and thank you cards for holiday, New Year’s, birthday and baby shower. Rounding out changes to our products portfolio, we updated our photo gift line to create excitement and cross sell opportunities to new and existing customers. This year we added new poster sized calendars and new seasonal calendar backgrounds.

We extended our innovative, center stage technology to large sized posters and we signed new content licenses allowing customers to include some of their favorite characters like Hannah Montana, High School Musical, Transformers, Disney’s Princesses, Winnie the Pooh, Mickey Mouse and the very popular Tinkerbell. And we launched a new line of personalized notebooks, notepads, address labels and stickers that are great for everyday use. Customers can also select our holiday designs to add an extra touch to their holiday gifts and correspondence. Early feedback from these new products and enhanced features have been very positive.

Along with our product innovations we continue to enhance our sharing service. As you may recall in August we launched our Share 2.0 service which combines the power and benefits of photo sharing, blogging, self publishing and social networking sites with a sophisticated security layer into one easy-to-use experience. Customers can now create their own personal password protected websites for friends, family, groups and clubs. And since launch more than 350,000 share sites have been created across a variety of use occasions for both personal, group and business purposes. More than 65 million photos have been posted across these 350,000 share sites.

Based upon user input since the August launch we added a number of new capabilities to increase adoption and modernization including the ability to sign in, create products and digitally post photo books directly from the share sites, a broader selection of design templates, improved usability for updating pages and pictures, a share tab providing a one stop shop for users to view all of their share sites and other shares in a single location and we launched our sponsorships and advertising initiative to further monetize our user base beyond product purchases. Some of our initial advertisers included top brands such as Sony, ABC, AT&T, Universal Music and Proctor & Gamble. Feedback from users and the press on our share sites have been fantastic.

Let me share with you just two of the many positive comments I’ve received from users: “I am completely technologically challenged but within a few hours I created an amazing website of our family’s vacation. My friends and family loved seeing our photos and reading about all of our activities including the engagement of our son. Thanks Shutterfly. This service is a real home run.” And that was from Anne Murray in Denver and from Michelle in Boston, “The new Shutterfly websites can be summed up in one word: awesome. I love it. What a great idea. Now the grandparent and friends can keep up with the kids easier and order as many pictures as they want. Thank you so much for this.”

To drive awareness and adoption of our new sharing service and our personalized products during Q4, we kicked off our new integrated marketing campaign. Let me describe a few of the highlights. We launched a holiday micro site featuring photo tips and tricks, card etiquette, gift ideas and customer stories to increase daily consideration and differentiate us as a premium brand. We created an interactive holiday card finder that helps customers choose the right card from the hundreds of choices we provide. We designed and mailed our holiday catalog and our direct mail pieces to both current customers and new prospects, showcasing the breadth and the depth of our product offering.

We launched a new advertising campaign focused on cards, photo books and share sites in more than 15 leading publications and we executed a number of seasonal promotions with partners including Target, [Topman Malls], David’s Bridal, Amazon, Borders, Exposures, Adobe and Archivers. The enhancements we’ve made to our products and services and our new integrated marketing campaign positions us well for the fourth quarter.

From a manufacturing standpoint, our teams in Charlotte and Hayward are ramped up and prepared and our existing and new outsourcing partners are online and trained to deliver on Q4 volumes. In addition to being prepared for the fourth quarter, the manufacturing team is on target to open our new Phoenix facility during the Q2 of 2009.

Lastly, I’m very excited to announce we entered into a strategic relationship with Group O, a leading provider of marketing services, print management and decision sciences for the Fortune 1000. Through this relationship, Group O and Shutterfly will jointly go to market with the unique integrated commercial printing solution. We are targeting companies seeking to dramatically enhance their return on investment on marketing campaigns through personalization and faster time to market. We are already seeing success from our Group O relationship and have begun executing on a direct mail campaign for one of their clients, a Fortune 50 company.

So that summarizes our key accomplishments for the third quarter and our preparedness for the seasonally busy fourth quarter. Now I’d like to make a few comments about the broader economic environment. Clearly, the United States is experiencing unprecedented decreases in liquidity, credit and confidence that are impacting consumers’ desire and ability to spend. However, this is not the first time Shutterfly has experienced difficult economic times. We weathered the 2001 to 2004 dot.com collapse and emerged a stronger and more profitable company. We did this by focusing on our customers’ needs and on the things that are within our control and that is exactly what we will do again.

We will focus on delighting our customers by delivering a world class user experience, innovative new products and services and outstanding quality and customer service. While visibility to Q4 is more limited than in the years past, I am confident that consumers will continue to connect with friends and family and give personalized Shutterfly greeting cards, photo books, calendars and photo gifts this holiday season.

In closing, I believe we have the right strategy to win in the large and early markets we are addressing. We are the leaders in our market with the best products, services and brand, a track record of profitability since 2003, a strong balance sheet with essentially no debt, a talented team with a history of executing in good and bad economic cycles and a commitment to financial discipline with a focus on improving free cash flows.

So with that I’ll turn the call over to Mark to review our financials in detail.

Mark J. Rubash

I’ll begin my comments today with some observations about our third quarter performance followed by a review of our key metrics and then a walkthrough of this quarter’s operating results. I’ll conclude my comments with an overview of our Q4 and full year 2008 financial guidance. Following that discussion we’ll open the call for questions.

As I’ve mentioned in each of our last three calls, we continue to execute against a very difficult economic environment that is putting enormous strain on consumer discretionary spending. The current credit crisis combined with a deteriorating economy and the unprecedented erosion of the consumer nest egg have clearly dampened consumer spending and greatly reduced consumer confidence. No business that I’m aware of is immune to the current economic challenges and there is no clear indication of when the environment might improve. As a result we remain intensely focused on the key elements of our strategy and ensuring that we position our company for the greatest possible success when conditions do improve.

So with that let’s now turn to our key metrics for Q3. During the quarter our key engagement metrics continued to show mixed year-over-year performance. Site visits sustained the low double digit growth rate that we saw in Q2 with fairly consistent linearity across the quarter. As expected, the growth in registered users slowed considerably over the prior year, primarily due to the large influx of users from last year’s migration from Sony and Yahoo. Unique uploaders and image sharers also showed stable year-over-year growth again with fairly consistent activity levels across the quarter.

During Q3 we had 916,000 transacting customers who generated nearly 1.7 million orders with an average order value of $21.71. This activity translates into year-over-year growth in customers of 9%, average order value of 11% and essentially flat order volumes. The average order volume improvement was largely the result of a continued mix shift from prints to higher value personalized products particularly to our award winning line of photo books.

Let’s now move through a discussion of our reported results starting with net revenues. Net revenues for the quarter totaled $36 million reflecting 10% year-over-year growth. The allocation of net revenues between new and existing customers was very consistent with the prior year at 22% and 78% respectively. In terms of product mix, net revenues from prints and personalized products and services totaled 46% and 54% respectively. Also, net revenues from 4x6 prints represented 29% of total net revenues, down significantly from the 37% revenue contribution in the prior year.

In terms of net revenue growth rates, prints declined to 8% year-over-year and personalized products and services increased 32% year-over-year. As most of you are aware, in September of this year we made a permanent price adjustment on 4x6 prints lowering our every day price to $0.15 and reducing the lowest tier in our prepaid plan to $0.10. While this pricing move did improve unit volumes in a very competitive market, the volume increase was not sufficient to offset the revenue loss from the price change. However, we continue to believe that these new price levels are competitive and appropriate given our overall value proposition and quality.

In addition, even at the reduced average selling price level, our low manufacturing cost continues to provide strong profit contribution from 4x6 prints. Moving to cost of net revenues and gross margin, we reported a gross margin of 49% during Q3, a two percentage point improvement from the prior year and well ahead of our expectations. This strong margin performance resulted from several factors including continued labor efficiencies from our Charlotte plant, improvements in both materials and shipping costs and reduced costs for equipment rental.

Technology and development costs total $9.6 million for the quarter and includes year-over-year increases of $1.1 million for depreciation, amortization and stock based compensation. Excluding these amounts our technology and development spending increased approximately $900,000 or 19% from the prior year. Approximately two-thirds of this amount is attributed to cost increases for power, collocation space and bandwidth with a balance associated with headcount investments we’re making to improve the depth and quality of our product and services offerings.

Continuing down the income statement, sales and marketing costs totaled $10.1 million in the quarter representing 28% of net revenues and a 43% increase from the prior year. Approximately two-thirds of the year-over-year increase is associated with expanded online media and direct response marketing campaigns with the balance primarily associated with the expansion of our internal marketing team.

Our customer acquisition costs in Q3 increased approximately 32% from the prior year as a result of these expanded programs, many of which are targeted at Q4 customer and revenue growth. General and administrative expenses for the quarter totaled $6.8 million or 19% of net revenues compared to $7.4 million and 23% of net revenues in Q3 of last year. Included in general administrative expenses during the quarter were increases for new employees, our ERP implementation and office lease expansion, offset by efficiencies from our Sarbanes-Oxley compliance efforts and reduced contractor utilization.

In addition, we also recognize the first installment from our second IP licensing transaction, a two year cross licensing agreement with a private, venture backed ecommerce company. The total fee under this arrangement is in the low single digit millions and the second roughly equal installment will be recognized in Q3 of 2009. Continuing the discussion, adjusted EBITDA for the quarter was a positive $100,000, far better than our guidance which estimated a loss ranging from $4 million to $6 million. This EBITDA improvement resulted from a consistent sustained effort across the entire business to manage our cost structure in line with our revenue growth and is strong evidence of our commitment to deliver increasing profitability and free cash flows.

Effective tax rate for the quarter was 69%, within our guidance range but higher than the 45% rate reported in Q2 of this year. The rate increase is attributed primarily to a lower full year forecast for pretax income, offset partially by the identification of additional R&D tax credits. As a reminder, please note that our cash tax rate continues to be extremely low due to the availability of net operating loss benefits and that our GAAP tax rate is very sensitive to changes in either pre-tax income or permanent tax differences.

On a GAAP basis, our net loss for the quarter totaled $2.7 million or $0.11 per share. On a non-GAAP basis which excludes stock based compensation and purchase accounting amortization, the net loss totaled $2.9 million or $0.11 per share. Shares used to compute the quarterly net loss totaled $25.1 million.

Now I’d like to provide some additional insight on our capital expenditures and on our cash investment and liquidity status. Capital expenditures during the quarter totaled $6.4 million which included $3.6 million for technology equipment and software, $1.4 million for manufacturing and office equipment and $1.4 million in capitalized software development costs. Cash and liquid investments at September 30 totaled $40.6 million.

In addition, we continue to carry investments in student loan backed auction rate securities which had a fair value at quarter end of $47.4 million. This revised valuation reflects an additional impairment during Q3 totaling $1.4 million which is reflected net of tax on the balance sheet as a component of other comprehensive income.

On October 8 of this year we received a formal rights offering from UBS that would entitle us to sell our auction rate securities to UBS at par value plus accrued but unpaid interest during a period from June 30, 2010 through July 2, 2012. In exchange, UBS affiliates will have the discretionary right to sell our eligible auction rate securities on our behalf without prior notification so long as we receive par value for the sold auction rate securities. We are currently evaluating the terms of the rights offering and must decide whether or not to accept the offer no later than November 14, 2008. For your reference, all of our auction rate securities continue to be AAA rated and we continue to receive interest payments on schedule.

Regarding our cash resources, we are confident that the $40.6 million in available liquid cash and securities balances is adequate to meet our current and future operating cash requirements. To further ensure that we have full strategic flexibility while the auction rate markets are being resolved, we continue to maintain a $20 million line of credit that is available through April 29 of next year.

To complete my discussion today I would now like to summarize our outlook for Q4 and the full year 2008 together with some additional insight on our underlying assumptions. Like most retail and consumer ecommerce companies, since late September and continuing through this week we have seen a noticeable slowdown in traffic to our site and in order volumes for our products.

Considering the magnitude of the current financial crisis and the recessionary pressures on all Americans, this business decline is to be expected. While the trend is not favorable it is also important to note that historically we have generated the majority of our Q4 revenues during the period from the day after Thanksgiving through the date of our last shipping cutoff before Christmas day. As a result these early quarter trends are not necessarily indicative of the environment we will see during our peak holiday shopping period.

It’s also important to remind everyone that with Thanksgiving landing late in the month this year, our peak holiday shopping period will be five days shorter than last year. Given this combination of weak early quarter trends, very low consumer sentiment, limited discretionary funds and abbreviated shopping period we believe that this Q4 will be our most challenging on record and that our top line results will be difficult to predict.

As a result we have lowered our net revenue guidance for the quarter and retained the $15 million guidance range we have carried throughout the year. In terms of our cost structure for Q4 we have already implemented a number of cost management strategies in an effort to preserve the opportunity for full year profitability and free cash flow growth across the range of our revised revenue estimates. However, in the event that net revenues fall to the low end of our guidance or below, it is unlikely that we will be able to maintain our EBITDA margins in the 16% to 18% range as previously guided.

Regardless of the results we deliver in Q4 we continue to be confident in our strategy and our ability to execute in this challenging environment and will not move away from our commitment to deliver increased profitability and free cash flows in 2009. With these comments as context, I’ll now turn our guidance for Q4 and the full year 2008.

Starting with Q4, we expect net revenues to range from $89 million to $104 million which reflects year-over-year growth of up to 7%. We expect our GAAP gross margin to range from 56% to 58% of net revenues and our non-GAAP gross margin to range from 57% to 59%. We expect our GAAP operating income to range from $16 million to $27 million resulting in GAAP operating margins from 18% to 25%. We expect our non-GAAP operating income to range from $19 million to $29 million resulting in non-GAAP operating margins ranging from 21% to 28%.

We expect our adjusted EBITDA will range between $25 million and $36 million. We expect our GAAP effective tax rates to range between 50% and 57% and our non-GAAP effective tax rate to range between 37% and 38%. We expect the GAAP net income per share to range from $0.26 to $0.49 per share and the non-GAAP net income per share to range from $0.45 to $0.68. For folks who have calculating diluted net income per share, the weighted average common and potential common shares are expected to approximate 27.1 million.

Turning now to the full year 2008, we now estimate that net revenues will total between $195 million and $210 million reflecting year-over-year increases ranging from 4% to 12%. We expect the full year GAAP gross margin to range from 52% to 54% of net revenues and our non-GAAP gross margin to range from 53% to 55% of net revenues. This revised guidance includes approximately $1 million for severance, relocation and accelerated leasehold amortization associated with the closing of our Hayward plant.

We expected that our GAAP operating margins would range from a loss of $9 million to income of approximately $1 million. We expect that our non-GAAP operating income will range from $1 million to $12 million. We expect that our full year 2008 EBITDA margin will range from 13% to 17% of net revenues. The full year GAAP effective tax rate is now expected to range from 22% to 50%.

The full year non-GAAP effective tax rate is expected to range from 12% to 32%. We expect the full year GAAP net income per share to range from a loss of $0.13 to net income of $0.11 per share and the non-GAAP net income per share to range from $0.13 to $0.36. For purpose of calculating full year GAAP and non-GAAP diluted EPS, we estimate the average common and potential common shares outstanding will approximately $25 million in the event of a net loss and $27 million with respect to net income.

Finally, we expect that full year capital expenditures will approximately 13% of net revenues, down from the 15% level provided in our prior guidance and a substantial improvement over the 18.7% reported in 2007. So in summary, in light of the uncertainty and the extraordinary challenges presented by the current economic environment, we have reduced our Q4 and full year net revenue and profitability guidance to prudent levels.

In addition, we have already taken the steps necessary to preserve the opportunity to achieve full year profitability and increase free cash flows in 2008 and remain committed to further improvements in profitability and free cash flows in 2009. Finally, given the importance of our Q4 results to our 2009 planning, we have decided to provide our initial 2009 financial guidance when we report our full year 2008 results in early February of next year.

With that, I sincerely thank you for your time today and look forward to speaking to many of you in the days and weeks ahead. We’ll now open the call for your questions.

Question-and-Answer Session

Operator

(Operator Instructions) Our first question comes from Imran Khan – JP Morgan.

Imran Khan – JP Morgan

Two questions, first I’m trying to understand the trend inter quarter and what you are seeing in the fourth quarter. You talked about softer towards the end of September and the beginning of October. Could you please quantify that, give us some more color? Is it down on a year-over-year basis, the average daily volume? That would be very helpful.

The second question is with regards to sales and marketing cost up 43%, customer acquisition costs up 32% but I believe the customer growth rate was 9%. Do you think it makes sense to continue to invest in sales and marketing considering consumer sentiment is so low?

Mark J. Rubash

With respect to what we’ve seen since September I won’t quantify any specific numbers but I would say that in terms of traffic to our site we’re seeing very similar types of patterns. Some of you looked at the recent Hitwise report that was published on consumer and retail ecommerce. We’re definitely saw some consistency with that information and it’s not surprising given the amount of interest and concern about the financial crisis that stated in late September and through October.

I would say that it is concerning for sure but it’s not alarming at this stage. I think also keep in mind that October represents a relatively low percentage of our total Q4 revenue. It’s enough to be concerned about and I think anything that takes the consumer’s mind of their spending habits is going to impact everybody.

Jeffrey T. Housenbold

I’ll take the second question and just quickly add a little bit to what Mark was saying. I think what we’re saying is that consistent with overall ecommerce and the dampening in the visitation and the purchasing given the historic down draft in the financial markets over the last three weeks but we’re seeing continued visitation and market share that is consistent with our leading position.

I think in a couple of weeks in Info Trends will launch their market share numbers and confirm that we haven’t been losing share, in fact we’ve maintained our top position and gained on Snapfish. It’s really a macroeconomic trend not a competitive one. In terms of sales and marketing, Imran I think there’s a couple of things interplay here. I think one is our headcount, we grew the headcount in the marketing team and some of that our product marketing people who are building future feature functionality like our new share site, the enhancements to photo books.

Some of those are creative designers who’ve launched hundreds of new designs and layouts in both our photo books, our cards and our new social stationary line as well. Then some of that marketing dollars in Q3 were behind those new launches of our stationary and our share sites and a little bit of the increase is we dropped our catalog earlier this year. Some of that costs was hitting in Q3 where it hit in the fourth quarter last year.

On a go forward basis as Mark and I indicated in our prepared comments, we’re going to continue to have strong financial discipline and match our expenses against the revenue opportunity knowing that if consumers are not in a position to spend you can market to them all day and it’s not going to have an effect. So, most of our marketing is online, it’s performance based, it’s keywords and it’s strategic partnerships that are on a bounty basis. We’re aligning our expense with the revenue and we’ll continue to be prudent and disciplined in that area.

Operator

Our next question comes from Troy Mastin – William Blair & Company.

Troy Mastin – William Blair & Company

I’m intrigued by your commentary regarding the commercial printing solution and the partnership that you mentioned and what your executing a campaign for a Fortune 50 company, I wondered if you could maybe quantify currently how that’s impacting your business and where you see the opportunity and when you see that opportunity materializing?

Jeffrey T. Housenbold

Let me talk quickly, provide a little more color around the strategy. We talked at length last call about going to market and using the assets that we have in terms of digital print on demand, the scale of that capacity that we have, the expertise that we have and being a direct-to-consumer business understanding how to utilize CRM and segmentation and responsiveness to drive higher ROI campaigns.

We were fortunate to meet with Gruppo and formulate a relationship where they have an expertise in both packaging and direct mail campaigns for Fortune 1,000 companies and what they’ve typically done is partnered with a myriad of printing companies who have a much smaller footprint than we do. By combining forces we’re now able to crawl up the value chain and go to these very large advertisers who are doing large campaigns and who want to have an increased personalization of their collateral to stand out from the crowd and the ability to segment their database in to smaller runs across multiple segments.

That’s what the digital press has allowed us to do. So, we engaged with Gruppo and one of their very large customers, a Fortune 50 was intrigued by the concept and we’re in the middle of executing against that first program. That has happened over the last week or so where we’re actually printing and dropping the pieces in to the mail stream so we’re very happy abut the relationship.

We’re excited about this proof of concept with a large customer because we believe once we execute on this, this will give us a calling card to continue to drive additional business going in to 2009. I’ll let Mark talk a little bit about how we see the contribution of revenue coming in from that deal in Q4 and where we kind of think going forward the potential is.

Mark J. Rubash

With respect to Q4 I would keep in mind that this is the first program with Gruppo and really the first sizeable program that we’ve had to it’s early days for that project. I think there’s the possibility of $500,000 of revenue coming from that in Q4. I’m not prepared to give any estimates for 2009. What I have said in prior comments is our capacity across 2009 at our current pricing levels probably puts us in the $30 million to $40 million of capacity for commercial print work doing it in ways that do not impact our consumer business at all.

We’ve recently added three very experienced people to the commercial team who are very active right now in building a pipeline to help fill that capacity. So, we will absolutely keep you informed as we make progress but, we’re very excited about where we are right now.

Troy Mastin – William Blair & Company

What’s your read on the margins that that business might carry?

Mark J. Rubash

I think it could be as high as 20% to 30% operating margins. It really is not adding incremental people or machines or plant. It really is the variable cost of printing itself. So, it’s going to be a healthy margin supplement for the overall Shutterfly business.

Troy Mastin – William Blair & Company

Then if you could help me understand the framework by which you put your fourth quarter guidance together? Specifically, the low end of the guidance range, what is contemplated there? Is it a continuation of the weak trends that you’ve been seeing in the last couple of weeks? Does it contemplate a further deterioration? Does it contemplate an improvement? What would the high end of the range contemplate?

Mark J. Rubash

You can imagine we’ve been modeling things every possible way we can. I think the most constructive thing to consider and the way we look at it at the highest level is that activity levels in the well call it non-holiday peak periods and those really run from October 1st through Thanksgiving. During those periods historically we’ve seen kind of growth rates normally the same as what we see in Q3 and they start building as you get to Thanksgiving.

From Thanksgiving to about December 19th is really the bulk of our business and it just historically has been an intense period of revenue and production. In terms of our guidance, I would characterize the low end of our guidance if the kind of what we’re seeing in these early days of October persist through the entire quarter and we don’t see a holiday bounce post Thanksgiving, we’re going to be towards the low end.

If we see growth rates in the non-holiday part of Q4 that are more similar to what we saw in Q3 and we get some type of lift during that peak holiday period, we’ll be closer to the high end. It’s really hard to gage whether it’s an existing user or new user what their sentiment is going to be and what their capacity for spending will be when we come to the post Thanksgiving period.

Troy Mastin – William Blair & Company

Then it sounds like for 2009 you’re targeting I think you said improved profitability and cash flow versus 2008. Correct me if I’m wrong on that. Then, what sort of revenue level, I know this is hard to answer based on mix and all sorts of other things, but what sort of revenue level would you have to deliver to still deliver improved profit and cash flow growth or contraction in revenue in 2009?

Mark J. Rubash

I’m not going to speculate on the revenue level at this point but I will say that throughout 2008 we have made a number of improvements in our cost structure that I think are going to bear more fruit in 2009 regardless of the revenue levels that we see. First of all, we’ll be operating under two very efficient manufacturing environments between Phoenix and Charlotte.

We’ve recently renegotiated our shipping contracts and those are already providing additional margin this year and they’ll continue next year. We have been very frugal I think in our headcount growth as we’ve gone through the year we’ve taken a lot of dollars out of G&A in particular and we’ve made some pretty strong strides in the area of capital intensity both on manufacturing through the outsourced programs in Q4 as well as in the storage environment, the technology we’re deploying there.

My perspective, unless it is a dramatic contraction in consumer ecommerce, I think our cost structure is going to serve us quite well next year.

Operator

Our next question comes from Kristine Koerber – JMP Securities, LLC.

Kristine Koerber – JMP Securities, LLC.

A couple of questions, first of all can you talk about the Phoenix facility and kind of the ramp up of that facility? I know it goes on line in the second quarter but do we have some testing before hand?

Jeffrey T. Housenbold

The Phoenix we’re under lease currently. We are about to finalize the construction plans for the lease hold improvements and we will actually start construction very shortly and the plan is to be up and be able to run live there in time for Mother’s Day. The target date is effectively April 1 in that area. So we do have, we are hiring people who will be running that plant. They’re working with us currently or will be working through the Q4 so they will be Q4 tested as that new plant opens but April 1 is the current target for go live.

Kristine Koerber – JMP Securities, LLC

Also, Fujifilm has now moved online in the photo processing business. Can you maybe talk about how they would impact you if at all going forward? I know they’re offering I believe $0.12 4x6 prints and then just lastly, looking at your model longer term, can you help us understand what the real underlying growth rate is of the business? Is this a 15% grower longer term? Is it 30%? How should we be looking at the business?

Jeffrey T. Housenbold

On the Fujifilm they’ve always had a direct-to-consumer site. It’s mostly been a showcase so that they can sell into the retail channel the enablement to power retailers to have web-to-store pickup or just store pickup on the kiosk side. So they sell the machines and they have always been focused on the retailers.

Tokyo bought a small company to improve the front end user interface because Fuji lost all of those white label retail relationships to Snapfish and Fuji was behind on the capability to have interface for their kiosks and for the web-to-retail. And so this was an attempt for them to try to recapture those businesses as a number of folks like Costco has recently left Snapfish and a number of other, the major players in retail have RFPs in the marketplace because they’re not happy that HP Snapfish has undercut them in the channel.

So we don’t see this as a particular threat from our part of the business. It’s really an attempt to regain the retail business. And keep in mind the market is very large and the web-to-mail part of it which we plan is the fastest growing and in retail you can’t make photo books and the cards and the calendars and personalized products and services which is the fastest growing part of the industry, fastest part of our growth and we believe the future of the industry in terms of memory keeping and printing.

And that really flows into your next question which is long term growth. We go back to look at, we look at the adoption curves and we look at the consumers’ desire to do more with their digital assets to be able to tell their stories in more unique and creative ways. And we think the tools that Shutterfly is providing is allowing them to do that in terms of photo books, in terms of our share sites, in terms of personal publishing and social expression through our new designer card lineup that extends beyond the holidays with the thank you cards and the invitations and personal stationary.

And so we look at the penetration rates today in that part of the market and it’s only 6% so we remain very excited about the future in terms of the penetration rates and the potential for further growth in the company and we’re making the necessary investments in future functionality in terms, and physical products to be able to capture that growth going forward.

Operator

Your next question comes from Youssef Squali – Jefferies & Co.

Youssef Squali – Jefferies & Co.

A few questions. First, I guess, Mark, on the commercial print initiative that you have. Is there any additional cap ex that’s involved there and then on the second initiative that you talked about in your press release, the other exciting opportunity, can you flesh out that idea for us? How are you planning on doing it? What liquid assets do you have so far? What relationships do you have right now that’s going to make that a reality? And I have follow up.

Mark J. Rubash

I’ll take the first part on the capital on the commercial side. There is a small amount of equipment and we actually did some of that in Q3, typically involving things like UV coating. It’s pretty minor and modest. It should not involve any incremental acquisition of actual printing devices themselves in the short run though. It’s pretty minor if anything.

Jeffrey T. Housenbold

Yes and just adding on the cap ex side, our guidance that Mark gave of 13% is considerably lower than the 18.7% last year and keep in mind within our cap ex we include both the capitalized R&D as well as the ERP investments that we’re making this year. So we believe that there’s further leverage in our capital expenditures as a percentage of revenue going forward which is what gives us confidence in the ability to continue to drive additional free cash flow.

In terms of advertising we’re excited about the initial launch this past quarter in starting to monetize the active user base we have in terms of the tens of millions of photos that are being shared across the Shutterfly network each and every quarter. So we’re getting very receptivity in the market place given the demographic of our users primarily 75% female, $90,000+ household income, 25-55, half have kids in the household. It’s a very desirable demographic and we have such a strong relationship with those customers demonstrated by our high loyalty and repeat rates. So we’re getting very good receptivity.

We have a small team going after it, and as I indicated in my comments this is really about incubation. We’re going to continue to pay as we go, so taking the profits from that advertising and continuing to invest to grow the type of capabilities we could provide to these advertisers that build a unique relationship with the customers beyond simple banner advertising.

Youssef Squali – Jefferies & Co.

We’ve been hearing of customers having some difficulty with the service, some finding it very slow and others not being able to place orders and having to do it over the phone. Are these just off exceptions or have you experienced more issues in October? And lastly, not to beat a dead horse about ’09, I know you’re not yet guiding to it, but would you expect to see positive revenue growth in ’09?

Jeffrey T. Housenbold

Let me take the site issues. We haven’t experienced in October any major site issues to my knowledge. From time to time certain customers will have challenges based upon their ISP or their broadband connection depending on their computer configuration but nothing outside of the norm. We’ve been able to take orders and continue to have the high service level.

We experienced some challenges in early Q2 as we simultaneously launched Lightbox, Public Gallery and now New Media storage platform all at the same time, but those challenges were quickly resolved and behind us.

So we feel good about our Q4 readiness in terms of capacity and bandwidth and servers and ability to upload.

I think sometimes customers who might use multiple services have a sense that uploading to Shutterfly is slower and that in fact is the case because we’ve continued to hold the high resolution image where our competitors are doing significant down-sampling and compressing of the image, which is fine for 4x6 printing but doesn’t allow you to have the great quality we do in the photo books and the enlargements and the areas of growth that the consumers are desiring. So it’s a trade-off of a little bit of speed on the upload to make sure that your memories are safe for generations to come.

In terms of 2009 guidance, as Mark indicated Q4 is such a large part of our overall annual revenues and with the visibility in the market place not idiosyncratic to Shutterfly, we’re going to refrain from giving ’09 revenue guidance until we get through this Q4. Then we’ll give you guys an update in late January or early February.

Operator

Our next question comes from Derek Brown – Cantor Fitzgerald.

Derek Brown – Cantor Fitzgerald

I wanted to break apart revenue a little bit. In the quarter it looked like personalized products revenue growth actually accelerated from the second quarter and didn’t show the same type of sequential dip, at least not to the same degree I should say, as you saw last year. Conversely, the print business fell off rather dramatically. Number one, what in the personalized business may have accounted for the sequential acceleration in revenue growth? On the print business I realize that you lowered prices in September. Can you help break down the volume versus price change in the year-over-year revenue growth?

Mark J. Rubash

In terms of the acceleration on personalized products, that is absolutely the case. From Q2 we were at 26% going up to 32%. The absolute lion’s share of that acceleration was in the photo books. We had a very solid performance in photo books in Q3. There’s a fair number of promotions and ease of use features that were put in place.

In terms of prints I would say absolutely if you look at volumes across all the different print SKUs, particularly 4x6, they were in healthy double-digit areas given the competitive environment. So I attribute the decline to a couple of things. One, certainly the change in pricing, but two, last year when we had this large influx of Sony and Yahoo customers migrating to Shutterfly we also ran a number of fairly significant print promotions.

So the print category last year I think was healthier than maybe it had been historically because of one, a lot of new user migrations from other services as well as a print intensive marketing and promotion approach last year.

As Jeff said, we don’t believe that we have lost any share in terms of revenue based on independent surveys that have been done and we still believe that given the overall value proposition that our current price point is the right one for right now.

Jeffrey T. Housenbold

From a strategic standpoint that’s the trend we want to continue to push. Make a very nice profit from the 4x6 prints being the low-cost provider but we’re taking those profits and funneling them into diversifying the product line and continuing to innovate in the personalized products and services area.

The other nice trend that we’re seeing which is part of the lift in AOB throughout the whole year is a greater increase of new customers who are engaging with us in their first order beyond the 4x6 print. As the awareness of the personalized products and services championed by the photo book line continues to grow in the addressable market, we’re seeing new customers adopt that over 4x6 prints.

Operator

Our next question comes from Jim Friedland.

Jim Friedland – Cowen & Company

A question regarding the outsourcing strategy of incrementally bumping that up. As you look to ’09 and 2010, how far do you think you can actually increase that ratio of more outsourcing? Do you think you’re pretty much at a steady state after Q4 this year or can you actually increase that percentage over time?

And the second question is on the technology and development excluding stock-based comp. It was running at about 15% of total revenues and then this year there is the economy and you invested more. If we return to more normalized economic conditions, can that drop back down to a 15% type number or is it just going to be at a higher rate going forward?

Jeffrey T. Housenbold

I’ll take the outsourcing one and Mark can talk to the tech and dev. We believe that there is enough excess capacity in terms of digital presses in the industry from large commercial printers who are not focused throughout the year on the consumer side for us to continue to increase the level of outsourcing for a number of years. We are holding relatively steady our own internal capacity utilizing that capacity more efficiently throughout the year through the commercial printing strategy and then we’ll continue to outsource for the peak volumes in the fourth quarter. That combination along with some of the initiatives that we’re undertaking on the storage part of our cap ex stack is allowing us to have dramatic decreases in overall capital expenditures.

Mark J. Rubash

With respect to technology, we tend to think of each of the line items as focused on first decide what’s the heart of the strategy and then figure out what resources are necessary to execute on that strategy. So we don’t try to manage necessarily percent of revenue. But having said that, I think for Shutterfly the biggest opportunity is really continuing to push the boundaries of innovation on our products and I would expect that we would have stable or increasing investments on the technology side and look for efficiencies and leverage in other parts of the P&L as we go forward.

Operator

Our next question comes from Alan Gould – Natixis Bleichroeder, Inc.

Alan Gould – Natixis Bleichroeder, Inc.

I’ve got two questions. First, regarding cap ex in the Phoenix plant. How much should cap ex be in ’08 and ’09? Is ’09 the peak year?

And secondly, your midpoint of your 4Q revenue guidance is a shade below your 4Q07 number. If ’09 revenue is less than ’08, what leverage do you have in addition to the efficiencies you’ve already discussed to make sure your free cash flow is positive?

Mark J. Rubash

With respect to cap ex on Phoenix, we expect a relatively modest level. It could be in the $1 million to $2 million in total cap ex. The lease arrangement we negotiated has a fairly sizable tenant improvement allowance that will cover most of the infrastructure build there. In terms of equipment it’s really just relocating equipment from Hayward to Phoenix. So relatively modest capital expenditure on the manufacturing side this year and next year.

I tried to bring that out in my prepared comments in that it’s going to be very difficult to know until certainly the first couple of weeks after Thanksgiving where we’re going to track. We’ll have indicators before then. There’s a level of discretionary marketing that we can preserve but there’s really not a significant amount of freedom for Q4 given how late in the quarter it’s going to be until we actually know.

If you look at the range of our guidance and look at potential EBITDA and cap ex guidance, at the low end of our revenue range we do expect free cash flow growth from last year which was about -$2.5 million. The high end could be as high as $10 million or $12 million incremental free cash flow. But in the short term we think we’ve managed the levers that we have. There’s a few more that we can deploy and once we understand where Q4 is going then we’ll finalize our strategy and go forward into 2009.

Operator

Our next question comes from [Gary Schnirou].

[Gary Schnirou]

Can you talk about generally your cap ex going forward and what’s kind of discretionary? Could that potentially be down on an absolute basis next year by not spending so much on storage?

Mark J. Rubash

From my perspective there’s no such thing as discretionary cap ex. It’s got to prove itself and it’s got to be necessary to support the growth in the business before we spend it. I think the things to keep in mind are: One, this year we had an ERP system which is about $3.5 million that was included. That’s a nonrecurring number next year. I don’t know the level of capitalized R&D but it could be a couple million or more next year which is pretty consistent with 2008.

The biggest lever is really in the technology side and in particular storage. We continue to work all of the levers on that front. We’ve been following the hardware adoption curve. We’ve introduced new vendors to the storage stack this year that have saved us considerable amounts. We are continuing in pilot mode with a tape archive system that would give us the ability to archive the oldest images that are currently on disk to archive them to a tape environment which is about a 30% reduction of the actual storage costs.

And we’re continuing to look at both our policies and the opportunity to monetize storage at some level that is clearly beneficial to the consumer from where most of our competitors are. So yes I do think there’s absolutely the possibility that we could have reduced year-over-year cap ex next year.

[Gary Schnirou]

Do you think you would make the decision regarding amount of storage for consumers or charging or whatever change it would be for consumers, would that be a first half of next year decision?

Jeffrey T. Housenbold

We’re not in a position to talk about the timing. I think from a philosophy standpoint if you look at the competitive set out there from Yahoo’s Flicker to Google’s Picasa to smaller companies like Smugmug or what Adobe or Microsoft is doing, they all give away a small amount of free storage and then if you want to use that as a preservation site, you have to pay for it. That pay ranges from $25 to $75 per customer on an annual basis.

So we believe the consumers are conditioned to and understand the need to pay for storage and that acceptance continues to rise as more and more customers are adopting video as an adjunct to their photos in terms of memory preservation.

The way we look at it as the leader in the space is: How do we make sure that we don’t’ just go out and charge for storage per se but given all the leverage points that we have in terms of physical products and other feature functionality that we think we’re in the position to actually provide a premium subscription service that would combine across the different parts of the consumer value chain and provide a higher value proposition and a segment to the customers would be willing to pay for that premium subscription which might include a storage component. We’re continually testing and innovating around this area and we’ll have more to talk about in 2009.

Operator

There appear to be no further questions at this time. I’d like to turn the call over to Jeff Housenbold for any additional or closing comments.

Jeffrey T. Housenbold

Thank you to everyone for joining us again on this call. I think the key to remember is Q4 is a very important quarter for us. Christmas is going to come. People even though the consumer sentiment is down, people are starting to nest and look at things that are more important in their lives in terms of family and friends. And we think the products that we’re offering meet that kind of secular trend.

On a competitive basis the new innovations we’re making in improving photo books, improving our card finding to design choices to layouts and our new share site positions us very well for the fourth quarter but also as the economy gets healthier we think the adoption rates on our new products and services are going to be robust and we remain very committed and excited about the future potential for Shutterfly. So we’re going to go back and execute on Q4 and we’ll see you in January and give you an update. Thank you.

Operator

That does conclude today’s conference call. Again we thank you for your participation and you may disconnect at this time.

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