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Shutterfly, Inc. (NASDAQ:SFLY)

Q4 2008 Earnings Call Transcript

February 04, 2009 at 5:00 pm ET

Executives

Jeffrey T. Housenbold - President & Chief Executive Officer

Mark J. Rubash - Chief Financial Officer

John A. Kaelle - Vice President of Finance

Analysts

Kristine Koerber - JMP Securities LLC

Imran Khan - JP Morgan

Youssef Squali - Jefferies & Co.

James Friedland - Cowen & Company

Alan Gould - Natixis Bleichroeder

Mario Cibelli - Marathon Partners

Elizabeth Lilly - Gabelli

Operator

Good day everyone. Welcome to Shutterfly’s fourth quarter and full year 2008 financial results conference. This call is being recorded. I would like to turn the call over to Mr. John Kaelle, Vice President of Finance for Shutterfly. Please go ahead, sir.

John A. Kaelle

Thank you, operator. Good afternoon everyone and welcome to Shutterfly’s fourth quarter and full year 2008 conference call. With us today are Jeff Housenbold, Chief Executive Officer of Shutterfly and Mark Rubash, Chief Financial Officer. A press release detailing our results is available on Shutterfly.com and an archived copy will be kept on our site. We have also released some visuals that we will use as we get through 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 of this through the Investor Relations section of our website at Shutterfly.com. Before we begin, I would 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 which include risks and uncertainties. These forward-looking statements include statements about our business outlook and strategy and statements about historical results that may suggest trends for our business.

The Company's actual results may differ materially from those anticipated in the forward-looking statements due to various risk factors. 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 would 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. The presentation of non-GAAP financial information is not meant to be considered in isolation or to substitute for or superior to GAAP financial measures. A quantitative reconciliation of these non-GAAP financial measures to the most directly comparable GAAP financial measures is available in our Q4 and full year 2008 earnings press release which is posted on the Investor Relations section of our website at Shutterfly.com.

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

Jeffrey T. Housenbold

Thanks John and welcome everyone. Our agenda today will start with a review of 2008 and then some comments regarding 2009. Then I will turn the call over to Mark's review of our financial performance for Q4 2008 and full year 2008 in detail and provide financial guidance for Q1 and full year 2009. We will then open up the call for questions and answers.

As you listen to our remarks today, I would like you to keep in mind three key messages. First, I am proud of the Shutterfly team as they delivered a very solid Q4 and full year results despite an increasingly tough macroeconomic environment. Q4 marked our 32nd 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 believe 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 Q4 and full year results.

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 to Shutterfly.

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

During 2008, we focused on enhancing our products, services and user experience strengthening our branded franchise through a differentiated and integrated marketing, manufacturing high quality, high engagement products and incubating new businesses that leverage our manufacturing assets and our active customer base. Consistent execution against these strategic initiatives, our relentless customer focus and our financial discipline resulted in record financial results. We grew our transacting customers by 18%, orders by 7% and average order value by 7%. This translated into revenues of $213.5 million representing a 14% increase over 2007, a 17% increase in EBITDA and a meaningful improvement in free cash flow of $17.7 million.

Now, I will briefly recap some of the progress we made throughout the year starting with our products. Turning to photo books; throughout 2008, we continue to make enhancements to our award winning photo book line. In the first quarter, we launched Shutterfly dollar rate extending community and connectivity across the site inspiring our customers with new ways to tell their stories and reducing the time to make a photo book with the "make one like this" feature. Shutterfly Gallery is now in vibrant community with inspirational content and a team of 25 gallery guru volunteers. Over 25,000 books have been posted today and we have nearly 2.5 million unique visitors since launched. Many of our customers' inspirational stories and photos from the gallery have been featured in our site merchandising and advertising campaign.

To make it even easier and faster for customers to complete a photo book, we launched our Storyboard feature which offers user-friendly tools like a two real picture strip and a dynamic layout feature that automatically designs pages that fit the number and orientation of the photos. Customer's feedback on the Storyboard Tool has been very favorable. I thought I would share just two quotes from some of our delighted customers;

"This Photo Book Storyboard Tool has made my life so much easier. I can't even fully express it in words. For me, the benefit is really just that it cuts the time spend placing photos on pages to a tiny fraction of what it once was. Brilliant!" and "I used the new Storyboard Tool and I was amazed at how well it laid out the book along with how fast it was."

In addition to Gallery and Storyboard, we continue to focus on elevating our photo book designs. We launched new themed books for Mother's Day, Father's Day, Halloween and Christmas, 69 new layouts, 8 new digital scrapbooks in association with CK media and dozens of new scrapbook pages from leading designer, Lisa Bernstein. We also added new options on our square photo books to include padded and leather covers. These enhancements led to strong double-digit growth rates for photo books in 2008.

Now, moving on to cartoon stationery. We launched our first foray into premium designer stationery in Q1 centered on new babies and then expand it to other categories throughout 2008 including party invitations, baby showers, graduation and holiday from leading designer such as Erin Condren, Stacey Claire Boyd, and Fresh Lemonade. We are pleased with both the growth and the high customer satisfaction rates. In addition to our new designer line and in time for this holiday season, we updated our traditional greeting card assortment with hundreds of new classic fun and modern holiday design. Understanding key trends and applying innovative marketing and merchandising drove high retention rates during the fourth quarter. Rounding out our products category, we continue to enhance our photo gifts and based upon customer feedback, we expanded our product line this year to include notebooks, notepads, address labels, stickers and calendar posters. We also added a number of new license characters to our center stage product line including Hannah Montana, High School Musical, Transformers, Disney's Princess, Winnie the Pooh and Mickey Mouse.

We continue to complement our innovative products with enhanced services and user experience. In January of 2008, we acquired Nexo Systems and during the first part of the year, we successfully integrated the technology and the team into Shutterfly. In August, we launched our new sharing platform called Shutterfly Share sites. The goal of Shutterfly Share site is to be the best place on the web for families, friends and groups to create their own secure place to share memories and stay connected. Our sharing platform combines the power and the benefits of photo sharing, blogging, self publishing and social networking sites with the sophisticated security layer and an easy-to-use interface.

Adoption from our customers has been fantastic. We ended the year with more than 650,000 Share sites and more than a 116 million photos posted. From a business model standpoint, Share sites are driving customer acquisition, product sales and while still in the early stages, advertising revenue. Our advertising and sponsorship group launched in September and we carried campaigns from a number of leading advertisers including Casio, Proctor & Gamble, Universal Music, A&E Television, Sony and SanDisk. During 2008, we made a number of changes to improve and expand the experience of uploading, viewing and organizing photos. We launched a flash-based uploader that allowed customers to get their pictures off their cameras and unto Shutterfly quickly, easy and in just a few clicks.

We also launched a redesigned My Pictures section with an improved paradigm for organizing photos and creating products. The new My Pictures has improved the creation process and increased the velocity of non-print transactions. Lastly, through a relationship with ScanCafe, we added a scanning and a restoration service for our customers to share and print their non digital photos. With the additions in new products and services, we continue to expand our customer base through strategic business relationships with other top brands and with our integrated marketing approach. Let me recap some of the highlights.

Starting with our business relationships, in 2008, we expanded our current relationships with partners like Target, Archiver's, Delta, David's Bridal and Sony. We also added several new partners. First, we partnered with Adobe to integrate Shutterfly into the element software and photoshop.com. We launched co-branded content, educational classes and designs to CK Media to further penetrate the scrapbooking market. We teamed up with Proctor & Gamble's Pampers Gift to Grow program, extending our reach with new moms. We integrated into Santa photo sittings across majority of top line mall locations and we combined our experience with Exposures, a leading brand in the memory preservation space.

Now, turning to our integrated marketing efforts. We have a very successful year from an integrated marketing standpoint. We executed on a number of online and offline marketing campaigns centered on targeted solutions such as travel, baby and scrapbooking in addition to key holidays including Valentine's Day, Mother's and Father's Day, Halloween and the Q4 holidays. For example, we held our summer travel event between a Google map mash-up and a photo book sharing on Shutterfly Gallery. At Halloween, we launched the theme Share site event which inspired our customers to showcase their photos of crazy costumes and spooky Jack o'Lantern.

For the Q4 selling season, we created a holiday micro site featuring holiday card photo tips and tricks, gift ideas and inspiring stories from our customers. We helped our customers pick the perfect cards through advice from our Shutterfly card stylist and design suggestions from our unique holiday card finder. Additionally, we executed on our Cyber Monday promotional program that resulted in the largest shopping day ever for Shutterfly.

Finally, we launched our holiday catalogue and print advertisements and publications such as O, the Oprah Magazine, Better Homes and Gardens and Cookie, which drove significantly higher site visitation than other advertisers in the same publication. From a public relation and award perspective, 2008 was another banner year. Through our targeted outreach, we received more than 1.5 billion impressions in print, broadcast and online media outlets. We were featured prominently in the Wall Street Journal, the Washington Post, AP, USA Today, Real Simple, Town & Country and Self and we saw a 34% increased in broadcast coverage including the CBS Early Show, Bloomberg's Evening Edition, Rachael Ray, View from the Bay and E! News.

In addition to many industry accolades, we were named Best Photo Website for Moms by Cookie Magazine, the Number One Photo Book by Great Housekeeping Institute and once again, The Market Share Leader by InfoTrends. The culmination of the enhancements to our products, services and our marketing campaigns yielded positive returns through our figure and especially during the fourth quarter.

Now, let me make a few comments about manufacturing. Our internal teams in Charlotte and Hayward executed very well during the year. In fact, we set performance records that we are the best in the Company's eight year history. We deliver record volumes with more than 7.5 million transactions while maintaining our gross margins in a competitive environment. The manufacturing team also trained our outsource partners and streamline processes to ensure fast delivery and high quality level. In addition to executing during the fourth quarter, the manufacturing team made solid progress in our Phoenix facility which is on schedule and will open in the second quarter of 2009.

Lastly, the team, through our group of relationship, successfully completed the first phase of a multiphase direct marketing campaign for a Fortune 50 company. Our commercial printing efforts in Q4 yielded approximately $400,000 in revenue. Finally, we successfully kicked off our initiative to monetize our intellectual property portfolio. During 2008, we signed two license agreements resulting a multimillion dollar licensing fees paid to Shutterfly over several years. We intend to further leverage our patent portfolio in 2009.

So that summarizes our accomplishments in 2008. Given the economic backdrop, I am pleased with our results and the progress we have made in improving our market leading position. I want to personally thank our customers for their continued loyalty and patronage and our employees and partners for their tremendous contributions, not just in the high intensity fourth quarter, but throughout the entire year.

Now, turning to 2009. I anticipate the macroeconomic environment will continue to be extremely challenging but I am optimistic that customers will continue to use Shutterfly's products and services to connect with friends and family throughout the year. Our focus will be on expanding our lead in the photo book, card and stationery, and memory sharing markets. We will focus on the things that are within our control and the initiatives that will increase revenue, EBITDA, free cash flows and long-term shareholder value. There is more to do in 2009. Tough times create opportunities for strong companies to get stronger and we intend to do just that.

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 and services, the best brand, a track record of profitability since 2003, a strong balance sheet with exceptionally no debt, a deep bench of talented managers with a history of executing in good and bad economic cycles and a commitment to financial discipline that focus on improving free cash flows.

With that, I will turn the call over to Mark to review our financials in detail. Mark?

Mark J. Rubash

Thanks, Jeff. I will begin my comments today with some observations about our fourth quarter performance followed by a review of our key metrics and then a walkthrough of this quarter’s operating results. I will conclude my comments with an overview of our Q1 and full year 2009 financial guidance. Following that discussion, we will open the call for your questions.

As I have mentioned throughout 2008, we continue to execute against a very difficult economic climate. The credit crisis combined with a deteriorating economy has clearly dampened the consumer spending and greatly reduced consumer confidence. With no clear indication of when the environment will improve, we will continue to maintain our cost structure and capital investments inline with our revenue growth and remain focused on the key elements of our strategy.

Despite the significant headwinds, there were some clear positives for us in the Q4 holiday season. We set quarterly records for visits, unique uploaders, photo shares, customers' orders, average order value and net revenues. We also set records for Q4 unit volumes in every major product category from photo prints to cards and calendars to photo books. What became very clear during this Q4 is that our strong brand, combined with a relatively low cost, high sentimental value and a holiday-oriented product line, has the potential to produce solid operating results even in times of great economic challenge. So, now let us go a bit further into our metrics.

During Q4, our key engagement metrics continue to show the trends we experienced all year with low activity during the non-holiday period and stronger performance during the peak holiday shopping dates. Like most ecommerce companies, our October and November trends were generally flat to down with the period from Black Friday through mid December coming in relatively strong. For the full quarter, site visits were up slightly year-over-year with the majority of the growth coming in the December shopping period. Growth in registered users accelerated from Q3 but decline slightly year-over-year when compared to the very strong Q4 2007 quarter.

Unique uploaders and photo shares continue to show stable year-over-year growth with fairly consistent activity across the quarter. During Q4, we had nearly 1.6 million transacting customers that generated over 2.7 million orders with an average order value of $39.40. This activity translated into year-over-year growth in customers of 14%, average order value of 7% and 3% growth in order volumes. The average order value improvement was largely the result of a continued mix shift from prints to higher value personalized products particularly our award wining line of photo books.

Let us now move through a discussion of our reported results starting with net revenues. Net revenues for the quarter totaled $107.7 million reflecting 10% year-over-year growth. The allocation of net revenues between new and existing customers was 27% and 73% respectively, very consistent with last year's Q4. In terms of product mix, net revenues from Prints and Personalized products and services totaled 33% and 67% respectively. Also, net revenues from 4x6 prints represented 9% of total net revenues, down only slightly from the 11% revenue contribution in the prior year.

In terms of net revenue growth rates, Prints accelerated sequentially and/or essentially flat year-over-year. Personalized products and services increased 17% year-over-year led by continued strong double-digit growth in photo books. As most of you are aware in September of this year, we lowered our everyday price for 4x6 prints to $0.15 and reduced the lowest tier in our prepaid plan to $0.10. While this pricing will continue to generate solid volume growth, the volume increase is not sufficient to fully offset the revenue loss from the price change. We continue to believe that these new price levels are competitive and appropriate given our overall value proposition and quality.

Moving to cost of net revenues and gross margin, we reported a net margin, gross margin of 61% during Q4, a 1% each point improvement from the prior year and well ahead of our expectations. The strong margin performance resulted from several factors including continued labor efficiencies from our Charlotte plant and efficient management of our seasonal workforce, improvements in materials cost and lower overall shipping cost. Technology and development cost totaled $10.8 million for the quarter and includes year-over-year increases of $900,000 for depreciation, amortization and stock-based compensation. Excluding these amounts, our technology and development spending increased approximately $1.3 million or 24% from the prior year. Roughly half of this amount is attributed to cost increases per power, co-location space and bandwidth with the balance associated with the headcount investments we are making to improve the depth and quality of our product and service offerings.

Continuing down the income statement, sales and marketing cost totaled $15.2 million in the quarter representing 14.1% of net revenues down slightly from the 14.3% expense level in the prior year. Roughly 60% of the year-over-year increase is associated with expanded online media and direct response marketing campaigns with the balance primarily from increases in headcount within our internal marketing team. Our Q4 customer acquisition cost decreased about 4% from the prior year due partly to greater spending in Q3 of this year and also from improved performance from our Q4 promotion and discount strategy.

General and administrative expenses for the quarter totaled $10.2 million or 9.5% of net revenues compared to $9.5 million and 9.7% of net revenues in Q4 of last year. Q4 general and administrative expenses included increases for office expansion and legal expenses offset by efficiencies from our Sarbanes-Oxley compliance efforts and reduced contractor utilization.

Continuing in the discussion, adjusted EBITDA for the quarter was approximately $38.6 million far better than our guidance which range from $25 million to $36 million. This EBITDA improvement resulted from a consistent, sustained effort and managed our cost structure in line with our revenue growth in a strong evidence of our commitment to deliver increasing profitability and for cash flows.

The effective tax rate for the quarter was 49% resulting in a full year tax rate of 28% which was within our guidance range. The rate decrease over 2007 is attributed primarily to lower full year pretax income offset partially by the identification of additional RND tax credit. The rate decrease over 2007 is attributed primarily to lower full year pretax income offset partially by the identification of additional R&D tax credit.

As a reminder please note that our cash tax rate continues to be extremely low due to the availability of NOL benefits and that our GAAP tax rate is very sensitive to changes and either pretax income or permanent tax differences.

On a GAAP basis our net income for the quarter totaled $14.9 million of $0.59 per share. On a non-GAAP basis which excludes stock-based compensation and purchases accounting amortization, net income totaled $20.6 million or $0.81 per share. Shares used to compute the quarterly net income per share totaled $25.5 million.

Now, I would like to provide some additional insight on our capital expenditures and on our cash investment and liquidity status. Capital expenditures during the quarter totaled $2.7 million which included $1 million for technology equipment and software approximately $400,000 for manufacturing and office equipment and $1.3 million in capitalized software development cost.

For the full year capital expenditures totaled $22.7 million or 10.7% of net revenues, a significant improvement over our 2007 spend was totaled $35 million or 18.7% of net revenues.

During 2008, we significantly reduced our capital expenditures through a number of initiatives focused on both image storage and on manufacturing capacity. We will continue these and other efforts during 2009 with a goal of delivering a sustainable low level of capital intensity to our business.

Cash and liquid investments at December 31st totaled $88.2 million. In addition, we continue to carry investments in auction rate securities with a fair value of $43.3 million which reflects a total impairment of $9 million.

In November 2008, we accepted a formal rights offering from UBS that entitles us to sell our auction rate securities to UBS at par value plus accrued by unpaid interest during a period from June 30, 2010 through July 2nd, 2012. In exchange, we granted UBS the right to sell our eligible auction rate securities at par value without prior notification.

In connection with our acceptance of the UBS rights offering, during Q4 we recognized a $9 million impairment loss on the auction rate securities portfolio together with an approximate $9 million gain representing the fair value of the UBS right. The impairment loss and the offsetting gain from the UBS right are included as components of other income loss for the period.

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 $88.2 million in available liquid cash and securities balances is adequate to meet our current and future operating cash requirements. In addition, we continue to maintain a $20 million lineup credit as available through April 29th, 2009.

I would now like to summarize our full year 2008 results. During 2008 we had 2.8 million customers that placed over 7.6 million orders for an average order value of $28.20.

Net revenues for the year totaled $213.5 million, a 14% year-over-year increase. Personalized products and services contributed 61% of total net revenues, reflecting 23% year-over-year growth. Net revenues from Prints increased 3% on the year and contributed 39% of net revenues, and finally four by six Print revenues declined from 22% of net revenues in 2007 to 19% in 2008.

Despite operating two manufacturing plants for the full year combined with the loss of revenue and margin from our four by six price reduction. Our full year gross margin was 55% consistent with each of the past three years. Our full year EBITDA profitability rate improved to 18% and capital expenditures declined from 18.7% of net revenues in 2007 to 10.7% of net revenues in 2008. This careful management of both the top line and the bottom line delivered $15.6 million in the free cash flows during 2008, a $17.7 million improvement from the negative $2.1 million incurred during 2007.

So, in summary, 2008 was a challenging yet successful year for Shutterfly. We strengthened our products and maintained our market leading position. We refined our strategy and gained many new insights into the levers that drive our business. We demonstrated the strength of our product and overall value proposition in tough economic times and finally, we delivered on our commitment to increase profitability and free cash flows.

To complete my discussion today, I would now like to summarize our outlook for Q1 and a full year 2009, together with some additional insight on our underlying assumptions. The complete details of our initial 2009 financial guidance are included in our press release issued earlier today.

Like most retail and consumer e-commerce companies, since the end of the Q4 holiday shopping period and continuing through this week, we have seen the expected seasonal slowdown and traffic to our site and order volumes for our products.

Given the magnitude of the continuing financial crisis and the recessionary pressures on all consumers, we believe that 2009 will be our most challenging year on record and that our quarterly and full year top line results will be difficult to predict. Accordingly, we are being appropriately cautious with our revenue guidance and have increased the range of potential revenue results.

In terms of the components of net revenues we expect that we will see the continued trend of weak, non-holiday order volumes with modest year-over-year increases around the traditional holiday shopping period. We expect a consistent mix of revenues between new and existing customers with modest growth in average order values; and finally, we expect a continued shift to revenues from four by six and other Print categories to our line of personalized products and services.

With respect to our commercial printing initiative we continue to make steady progress with our Group O relationship, as well as with a number of new customers. During Q4 we generated approximately $400,000 in commercial print revenues and expect to substantially build on that amount during 2009, because our commercial initiative still early in the business development phase, we are not providing any guidance for 2009 today but we will report our progress to you each quarter.

In terms of our cost structure we have already implemented a number of cost management strategies during 2008 and we will continue those efforts in 2009. In addition last week we reduced our workforce by approximately 5% to better align resources with our strategy and to manage our cost structure inline with anticipated revenues. We expect that the majority of the workforce reduction cost which primarily impacted our non-manufacturing employees will be incurred during Q1 of this quarter. In addition, we are progressing on plan with the closure of our Hayward manufacturing plant and the build out of our new facility in Phoenix.

As a reminder, during this transition period we will incur a number of incremental costs during Q1 and early Q2 associated with increases for building leases, accelerated amortization of leasehold improvements, equipment moving, employee relocation, and severance costs, as well as training and other burn-in costs associated with a start of a new plant. And finally, while we remain firmly committed to our plan of increasing profitability and free cash flows, 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 at historical levels.

With these comments as context, I will now summarize our initial guidance for 2009, starting with the full year.

We currently estimate that net revenues were totaled between $190 million and $210 million reflecting a year-over-year decline of approximately 2% to 11%. Also please note that these amounts exclude any 2009 net revenues from our commercial printing initiative. We expect the full year GAAP gross margin to range from 50% to 52% of net revenues and our non-GAAP gross margin to range from 51% to 53% of net revenues.

The year-over-year decline is attributed primarily to margin loss from four by six Print pricing and 2009 costs for severance and the transition to our new Phoenix manufacturing plant. We expect that our full year 2009 EBITDA margin will range from 14% to 18% of net revenues and then capital expenditures will range from 11% to 12 % of net revenues.

Turning now to Q1. We expect net revenues to range from $28 million to $32 million which reflects a year-over-year decline ranging from 7% to 19%. We expect that our GAAP gross margin to range from 35% to 38% from net revenues and our non-GAAP gross margin to range from 37% to 40%. We expect our adjusted EBITDA will range from a loss of $3.2 million to a loss of $5.6 million.

So, in summary, in light of the uncertainty and extraordinary challenges presented by the current economic environment, we believe that our initial Q1 and full year 2009 net revenue and profitability guidance is appropriately cautious and reflects a significant uncertainty in today’s marketplace. In addition, we have already taken many of the steps necessary to preserve the opportunity to achieve full year profitability and increase free cash flows in 2009 and we will continue to focus on our strategy and strong execution in these challenging times.

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

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from the line of Kristine Koerber - JMP Securities.

Kristine Koerber - JMP Securities LLC

Congratulations on a good quarter. Couple of questions, first, on the guidance, given your primarily fourth quarter story here, I mean are you looking for trends to accelerate throughout the year? I mean how you are looking at the guidance? Or how should we look at the guidance you gave?

Jeffrey T. Housenbold

Without trying to be too specific by quarter I think really we are expecting to see the same types of patterns seasonally that we saw in 2008, even through this month we have seen pretty low levels of order volume in January just like we did last year about this time and then what we expect is growth spikes around the traditional gift giving holidays. There are a few things that moved around in terms of how the days land on the calendar this year. Q1, we lose a day because of leap year and then Easter is actually pushed in the Q2. So, you will see some shift around that. The Q4 holiday season is going to be fairly compressed this year, very similar to 2008. But I think the best guide at this point is to use fairly consistent patterns from 2008.

Kristine Koerber - JMP Securities LLC

Okay. That is helpful. And then looking at the trends around the non-seasonal period, are we talking the high teens kind of what you have guided in Form Q1 is that just trying to get an idea how soft business was.

Jeffrey T. Housenbold

In terms of the metrics, what we have seen so far in Q1, the activities on Shutterfly that are free, obviously visiting the site, registering, uploading, sharing all of those metrics continue to be quite normal and I will say healthy. We have seen a very traditional slowdown in order volume that comes as you exit Q4. So, typically our customers are kind of have a lot of holiday photos and there is a little bit of pent-up demand that continues into the early part of January and then the growth rates tend to come down to relatively flat towards the end of January.

Mark J. Rubash

And then we expect to see then to pick up going into Valentine’s Day, Mother’s Day, Father’s Day would be the three biggest holidays in the first two quarters.

Kristine Koerber - JMP Securities LLC

Okay, great. And then lastly, I mean what are you seeing in terms of the competitive market by the big two? Any change there?

Jeffrey T. Housenbold

No real change. I think when you look at the competitive landscape we are still the market share leader. We believe based upon our own internal channel checks that we took market share in the key categories of photo books, cards, and calendars from our two main competitors during the fourth quarter. Our new sharing platform, the share sites continue to attract new customers and we are pleased with the uptake there. We are not seeing any pricing pressure across the portfolio. We are feeling pretty good coming up at Q4 with our 10% growth relative to overall e-commerce with a down about 4%. So, we think the high retention rates and high repeat rates of our existing customers and the innovative products and services that we are offering will continue to attract customers throughout the year.

Operator

Your next question comes from the line of Imran Khan - JP Morgan.

Imran Khan - JP Morgan

Couple of questions. First, there are a lot of conversations about online advertising rate coming down. Are you seeing the advertising rate coming down? If so, is that baking into your guidance? Secondly, what sort of one-time expenses was in fourth quarter for moving facilities and then the last question is regarding once it move the facility to new location, what kind of gross profit margins improvement you might see from that location?

Jeffrey T. Housenbold

I will take the first one on ad rates and I will let Mark talk about the expenses related to the shutdown at Hayward and the opening of Phoenix and the implications for gross margins. On the ad rates, there are two sides to that coin, right? One is our expenditures where we are doing acquisition spending on paid search and media across the web and I think the IAC, the IAB and also Barry Diller's comments from IAC yesterday implied that CPMs are coming down and certainly across the networks and the social media sites so I think that will play favorably for us from a cost of acquisition standpoint. As it relates to us monetizing our share with our own sponsorship, we have more of a targeted sponsorship model than a broad based CPM or banner advertising program and our targeted demographic are very desirable so we still are pretty comfortable in being able to obtain higher CPMs in the industry for the select few tier-one branded partners that we are going to work with throughout 2009.

Mark J. Rubash

In terms of cost of the Hayward to Phoenix transition, the only thing that was unique in Q4 and this is something that we have had from most of 2008, we recognize severance cost if you remember. We announced the plant closing back in July of 2008 and from that point through the exit date for the employees which is primarily this month in January. We have been accruing the severance cost all along. In addition, once we made that determination, we have been recognizing accelerated leasehold amortization for the Hayward facility.

The combination of those two costs in Q4 was in the 500,000 to 600,000 range. As we get into Q1, there are all of those costs that will continue so about for those two items, about the same amount in Q1. We also will have basically lease/rent on three facilities for a period in Q1 as we transition out of Hayward and into Phoenix. We have a lot of moving cost relocation and so forth. The aggregate of those are in the $1.5 million to $1.8 million that we largely in Q1, a little bit into Q2 but we are still on track to open that facility and be in production in the April timeframe prior to Mother's Day.

So once we are up and running, we have gone through the ramp out and burn in and training with the almost completely new staffs in Phoenix except for some of the leadership members. We expect to start realizing particularly the labor cost benefits beginning in Q3 and certainly labor and then also shipping cost will be closure to our west coast customers for Q4. So really the benefits will start revealing themselves in the back half of 2009.

Imran Khan - JP Morgan

And just to clarify, the labor cost flows through your cost of revenue, right?

Mark J. Rubash

Correct.

Operator

Your next question comes from the line of Youssef Squali - Jefferies & Co.

Youssef Squali - Jefferies & Co.

I guess as a follow up to that, can you help us quantify the potential list you maybe getting, I guess or assuming all else is constant from labor and shipping?

Mark J. Rubash

On labor, the rate differential is approximately 30% to 35% versus Hayward and I would say that if you want to use a proxy, I do not have the exact labor hours in Q4 but in the neighborhood of 700 to 1,000 seasonal employees that worked in a pretty compressed timeframe starting with some ramp up in late October and then into December, I do not think I want to go any more granular than that but certainly if you think of some of the benefits we have been able to get from Charlotte this year, the labor rate structure is almost identical. The power cost in Phoenix are also very similar to Charlotte that becomes meaningful over time and in terms of shipping, I think it will be less of a benefit in labor but certainly meaningful as well when we are shipping to the western side of the United States.

Youssef Squali - Jefferies & Co.

Turning to free cash flow, I guess looking at free cash flow in 2009, if I will get your implied EBITDA and CapEx, I guess the first question is how important is it for you to protect the margins to get your free cash flow breakeven this year and then on CapEx, it looks to us like the implied CapEx is about $22 million that is up slightly from what you are doing in 2008, yet on double digit revenue decline. Why do you need to increase CapEx as the percentage of revenues and on an aggregate and absolute dollar as well in this kind of environment? Maybe you can just walk us through the kind of components of CapEx?

Mark J. Rubash

Yes, in terms of the, I think, the first part of the question, I think in this environment, we would certainly give up some margin to capture share and maintain customer base. We were probably no different in most ecommerce players in Q4 with the whole series of different promotions and discount strategy and I think that have proved very well for us and the lessons from the Q4 will continue to be applied in 2009. From a total CapEx standpoint, keep in mind that the largest portion of our CapEx relates to storage and storage related technology and even if people are not buying products under our ordinary discount policy, they upload photos. So the storage comes. There is not a complete connection or correlation with revenue growth. I would say that also there is a, with this much volatility in where revenue could end for 2009, I think you have to maintain some flexibility in your capital and operating structure to make sure you are able to respond to up or down.

So this is the beginning of the year guidance and it is largely consistent. I think the last piece in 2008 we spent $3 million to $4 million for financial and other systems. That will not be recurring but we will probably have in the neighborhood of at least a couple of million in leasehold improvements for the Phoenix facility but very little equipment requirement this year.

Youssef Squali - Jefferies & Co.

Okay and I guess my last question is did you recognize any revenues from the licensing agreements that you talked about in the fourth quarter and how should we be thinking about them in terms of 2009 contribution?

Mark J. Rubash

We did not, there were no new IT license agreements in Q4. We have two arrangements, both of them require periodic payments in Q1 and Q3 so those have been disclosed previously and the accounting for those are actually are reflected as a reduction of G&A expense. So the two licenses as we recognized in 2008 will have almost equal payments coming into us in Q1 and in Q3 of 2009.

Operator

Your next question comes from the line of James Friedland - Cowen & Company.

James Friedland - Cowen & Company

Just a quick follow-up on the free cash flow if you would give the change in working capital in 2008 that there was a benefit there and it look like it came from the crude and other liability in those curious that does have anything to do with the transition in terms of training facilities and also as you look at 2009 given that you are guiding to sluggish type growth to a decline, good working capital reverse or just not be as helpful? Thanks.

Jeffrey T. Housenbold

Yes. Keep in mind the free cash flow number that we disclosed today is using adjusted EBITDA less capital expenditures as a proxy for operating cash flows. If you take the operating cash flow number off our cash flows of our statement for the quarter I think the numbers are actually higher and we chose to use EBITDA 1 because we used that historically but also because of just the timing of the payment of our particular Q4 accounts payable if you used that as a run rate you might get off track so using a profitability measure less capital expenditures. I think it is the more reliable. I do not think there is going to be anything out of our normal accounts payable processing and the timing of those payments in 2009. There is nothing significant.

Operator

Your next question comes from the line of Alan Gould - Natixis Bleichroeder.

Alan Gould - Natixis Bleichroeder

Thank you. Jeff, I was wondering if you can give us some thoughts of what you are planning on doing with your cash balance. 2008 was, before you start saying the effects of recession seems earlier the most went to our pretty last year and ended up free cash flow positive. Are you looking at eventually buying back stock? Are you looking at acquisitions taking advantage of the weak environment or just holding up for the cash for now?

Jeffrey T. Housenbold

I am pretty proud of the team's execution ability to go from a slight loss of around $2.1 million last year to positive $15.6 million and starting to get leverage to our strategic outsourcing in the Fourth Quarter and now our improvement in our storage architecture. We are getting to continue down that path and free cash flow is a focus for the entire management team in the company. When we think about cash in today’s environment, cash is gaining and flexibility is what is most important.

When you look at we have $52 million of auction rate securities held on the balance sheet at a lower rate but we believe we will get access to that in 2010 and we have plenty of cash to operate the business so given our leadership position we think we are in a good spot to look at talking acquisitions as they relate to accelerating adjacent markets or developing greater scale in the current market that we serve. We will continue to look at those opportunistically as we have and make prudent and strategic acquisitions.

As it relates to a share buyback at this current state giving that about half of our cash is still tied up in the banks, we are not planning or have announced a share buyback at this point in time but it is something that we consider from time to time and given the reflections in the economy, we may come to that decisions down the road but right now we are going to hold on to our cash and hold on to the degrees of freedom that it provides.

Alan Gould - Natixis Bleichroeder

What do you think about when terms of international expansion these days?

Jeffrey T. Housenbold

I think the opportunity for social expression and personal publishing on a global basis continues to excite us and we are looking in various ways to extend our reach across the pond and so we will continue look at build by rent or partner opportunities but also thinking about the payback period and the level of investment required given again the uncertainty in the economy has slowed down some of those thoughts over the last 12 months and were we might have been if the economy did not suffer and the declines that we saw.

Operator

(Operator Instruction) Your next question comes from the line of Mario Cibelli - Marathon Partners.

Mario Cibelli - Marathon Partners

This has been answered but I will be doing just a little check. If we take your EBITDA range and your CapEx range, you are just saying, Mark, that minus that would be your sort of free cash flow guidance, is that right?

Mark J. Rubash

Correct.

Operator

Your next question comes from the line of Beth Lilly - Gabelli.

Elizabeth Lilly - Gabelli

I wanted to just to ask a question. Jeffrey, you talked about as the environment normalizes, what you see the EBITDA margins in this business generating, let us say two, three or four years now in your mind?

Jeffrey T. Housenbold

So Beth, we have not provided a long range model at this point and given the uncertainty in the economy were going to restrain from doing that on this call but I will say if you look at our historical gross margin, we showed improvement from 17.6% to 18% this year. Our EBITDA margin, if you look at that historically, we have been showing improvement over last few years even though the price of 4x6 prints have been declining we have been getting more efficient in our production and 4x6 prints this year represented roughly 18% of total revenue which is down from 22% in the pervious year. So as we continue to mix shift to the higher average order value products like photo books, cards and calendars, we think there is continued expansion there. So, we are going to work hard and drive in the top line but continuing to expand our margins and hands up free cash flow.

Elizabeth Lilly - Gabelli

Expand your EBITDA margins.

Jeffrey T. Housenbold

Correct.

Elizabeth Lilly - Gabelli

Yes. Okay.

Mark J. Rubash

The other thing I would add so that would relate to the consumer part of our business and even though it is still is, I will say, nascent we still believe there is a commercial printing opportunity and right now we have capacity at commercial print prices without adding additional machines or other equipment in the neighborhood of $30 million to $40 million of print revenue and that has an operating margin potential within a 30% range. So, if we are successful and continue to make progress on that front together with maybe a little more modest expansion of EBITDA margins on the consumer side, three to four years from now we are quite optimistic that we can be at much stronger position than we are today.

Elizabeth Lilly - Gabelli

Okay. And then I want to ask just to follow up from the question before me. So just in terms of, so that I will very clear about your free cash flow definition, so if you are guiding to $190 million to $210 million in revenue in next year and you take a 15% EBITDA margin in the mid-range of that. You get about $30 million on EBITDA and then you back out the $22 million in CapEx and so that would actually give you your free cash flow number. Is that what you are taking about?

Mark J. Rubash

That is correct, based on our initial guidance today.

Operator

(Operator's instruction) And gentlemen, it appears we have no further questions. Ladies and gentlemen, this will conclude today's Shutterfly's fourth quarter and full year 2008 financial results conference call. We do thank you for your participations and you may disconnect at this time.

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

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

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Source: Shutterfly, Inc. Q4 2008 Earnings Call Transcript

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