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Shutterfly, Inc. (NASDAQ:SFLY)

Q2 2009 Earnings Call

July 29, 2009 5:00 pm ET

Executives

John A. Kaelle - Vice President of Finance

Jeffrey T. Housenbold - Chief Executive Officer

Mark J. Rubash – Chief Financial Officer

Analysts

Analyst for Kristine Koerber – JMP Securities, LLC.

James Friedland - Cowen and Company

Youssef H. Squali - Jeffries & Company, Inc.

Imran Khan - JP Morgan Securities, Inc.

Mitchell Bartlett - Craig-Hallum Capital

Alan Gould – Natixis Bleichroeder, Inc.

Michael Olson - Piper Jaffray

Operator

Welcome everyone to Shutterfly’s second quarter 2009 financial earnings conference call. This call is being recorded.

I would now like to turn the call over to Mr. John Kaelle, Vice President of Finance.

John A. Kaelle

Thank you, Operator. Good afternoon everyone and welcome to Shutterfly’s second quarter 2009 conference call. With us today are Jeff Housenbold, Chief Executive Officer 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 also have released some visuals that we will use as we go through the call.

Additionally, within a few hours, we will release a recording of this call both in a streaming online format and through a downloadable podcast. You can access all of these through the Investor Relations section of our website at Shutterfly.com.

Before we begin I’d like to note that our discussions 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 sections entitled “Risk Factors” in the company’s last annual report on Form 10-K 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 differ 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 on our Q2 2009 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

Thanks, John, and welcome everyone. Our agenda today will start with a review of our 2Q 2009 performance followed by some brief comments regarding our 2009 outlook. Then I’ll turn the call over to Mark to review our Q2 financial performance in detail and to provide financial guidance for Q3 and a full year 2009. We’ll then open up the call for Q&A.

So let’s get started. Shutterfly delivered solid second quarter results. Q2 marked our 34th consecutive quarter of year-over-year revenue growth and we delivered the top line with better than expected margin. We continue to focus on innovation and execution across all sockets of the business with strong alignment of our top three strategic imperatives increasing our Photo Book, cards, and stationary and memory sharing businesses.

Now I’ll briefly recap some of our Q2 progress starting with our products and then turning to our services, marketing, and manufacturing efforts. Starting with Photo Books, we saw continued increases in awareness and adoption during Q2 as a result of a strong mix of promotions and creative inspiration around the Mother’s Day and Father’s Day holidays.

We continue to invest and innovate within our Photo Book category and recently introduced photo and padded cover option on 8 x 11 books, new soft covers for the 5 x 7 books, and launched a new 7 x 9 size soft cover Photo Book. We are also seeing positive benefits from our enhanced creation path and our new story board tool, both designed to reduce the time and complexity of making a Photo Book. Efforts like these will allow us to more quickly reach the mass audience and expand industry penetration rates that are still below 15%.

The quality and breadth of our designs and formats continues to separate us from our competition and draw industry accolades. In May, Ellen DeGeneres asked Shutterfly to create a custom Photo Book to celebrate the 1000th episode of her talk show. She featured the books on air, on her website, and on her Facebook page, increasing awareness for the category and support for the Shutterfly brand. Shutterfly Photo Books were also recommended in the Mother’s Day gift guides for the CBS Early Show and top tier moblogs including Cool Mom Pics.com. As we head into our fourth quarter, we will continue to introduce new features that make it faster and easier for customers to tell their story using our award winning Photo Book.

Now turning to cards and stationary. During Q2 we made significant enhancements to our rapidly growing stationary collection. Our collection is comprised of exclusive and stylish designs from industry leading designers and is distinguished by refined 110 pound certified 30% post consumer waste card stock and paper. Our new creation path and shopping experience improves the customer experience with a template driven approach that saves time and offers assistance for occasion based etiquette. In addition, our best in class in-house manufacturing ensures that Shutterfly customers receive exceptional quality printing and fast delivery times.

During the quarter we expanded our offerings for new moms, brides, and everyday occasion with more than 500 new designs. We introduced more baby shower, baptism, and birthday invitations, bridal shower invitations, and wedding save the dates, and adding corresponding thank you cards and address labels.

We also introduced graduation and moving announcements, personalized notepads, customer gift tags, and most recently, calling cards. These calling cards are also known as mommy cards, come in 50 different designs, and give consumers who don’t have a business card or those that don’t want to use their business cards for social occasions, a stylish way to share contact information.

In May we announced a partnership with premier Hollywood baby boutique Petit Tresor to create new additions to our line of baby stationary displayed exclusively at Petit Tresor’s two Los Angeles locations and available at Shutterfly.com. The new baby stationary line incorporates European sophistication, a trademark of the famous Hollywood boutique.

Our new stationary collection is making an impression on the industry and has received accolades from leading publications like People and Pregnancy magazine and top websites like Daily Candy, Martha Stewart’s Wedding, and Brides.com.

In addition to our stationary collection, we enhanced our 5 x 7 photo greeting card offering. Customers now have the ability to include images, graphics, and text in multiple layouts inside their cards.

Rounding out our Q2 product enhancements, we added new center stage posters and puzzles featuring the Jonas Brothers and Transformers to coincide with both movie premiers.

Now let’s review our progress on Shutterfly services and overall user experience starting with our share sites. As a reminder, the goal of Shutterfly share sites is to be the best place on the web for families, friends, and groups to create their own secure website, stay connected, and share their memories. Our sharing platform combines the power and benefits of photo and video sharing, blogging, self publishing, and social networking sites with a sophisticated security layer and easy to use interface. From a business model standpoint, share sites are driving customer acquisition and product sales and while still in the early stages, advertising revenue.

Share sites adoption continues to be strong. We ended the quarter with more than 1.2 million sites and more than 271 million photos posted, up from 920,000 share sites and 181 million photos posted in the most recent quarter.

In June we launched Shutterfly video which makes it easy to privately and safely share video with friends, family members, and groups on Shutterfly share sites. Powered by Motion Box, Shutterfly video enables users to upload and post video clips from their digital camera or camcorder to their own private or public Shutterfly share sites. We also launched our first premium service which offers unlimited storage of video for $29.99 per year. Video has been the most requested service from customers and since launch we’ve received outstanding feedback. In addition, the media has positively reviewed our new video offering.

Here is a quick quote from Jefferson Graham, who featured us in USA Today: “Unlike the traditional video sharing service like YouTube or Vimeo, Shutterfly provides an easy to create blog like page complete with personalized URL to share videos and pictures and bring in comments from friends. One quick share and access to Facebook, Twitter, and other sites are offered. As good as anything I’ve seen on the web. Share sites beat a blog because it compiles groups of photos and videos altogether in one place in a snazzy setting that looks like a graphic designer laid it out for you.”

In early April we launched our first application for the iPhone and iPod Touch. Users can now view, share, upload, and preserve their memories for free while on the go. In addition, users can post their iPhone pictures directly to their Shutterfly share site. Adoption of our iPhone application has been very strong from both existing and new customers.

We also made good progress on improving our funnel conversion metrics. We launched a newly designed home page which positively impacted registration, abandonment, and conversion rates and improved our national search rankings. We also updated our registration page and promotions engine which increased registration and transaction conversion rates and improved our ability to segment and target our marketing messages.

We also made improvements to the My Shutterfly section and released a new version of our iPhoto export assistant, making it even easier for Apple customers to use Shutterfly and reduce their upload times.

Continuing our site improvement ahead of the busy fourth quarter, we recently redesigned the entire Shutterfly store front. The new store front is focused on improving the conversion metrics from store pages to product creation. The enhancements include a more focused shopping experience, optimization for search engines, better merchandising across our growing array of products, and stronger calls to action. We will continue to test and enhance our new store front throughout the third quarter to optimize Q4 results.

That summarizes our progress on products, services, and user experience. Now I’ll briefly cover some highlights from our marketing and commercial printing effort. To complement are new stationary offerings for new moms and brides, we launched coordinated micro sites with tips, tricks, and inspiration. Our bridal destination offers tips on finding your wedding photography style, selecting your photographer, and planning out your perfect photos. Our baby microsite provides moms with helpful tips for photographing babies and children, choosing the right birth announcement, creating modern baby photo books, and more. The baby site also features the “What’s In A Name” baby card finder which lets moms enter the baby’s name and offers stationary ideas to suit that style.

During Q2 we also enhanced our promotion and CRM platforms allowing us to deploy more sophisticated targeting and one to one marketing messages which enhances relevancy, conversion, and yield optimization.

Now let’s turn to our commercial printing efforts. During Q2 we made continued progress building our commercial printing business. The team delivered $680,000 in revenue from 15 different clients, 8 of which were new; hired two sales people; and implemented new work flow systems and processes to scale the business.

We are pleased with the progress, particularly given the macroeconomic climate and the early stage of the initiative. We are making solid progress in developing a suite of products, services, and capabilities to expand our commercial printing footprint in 2010 and beyond.

MediaMaster, Inc. where he was responsible for product strategy & design, product development and technical operations. He was part of the founding team of Walmart.com, and was responsible for development and operations. His previous experiences also include CTO at Velosel, and CTO of Homewarehouse.com which was acquired by Walmart.com. During Q2, Neil Day joined the executive management team as Senior Vice President and CTO. Neil’s entrepreneurial experiences and his success scaling large e-commerce platforms along with his leadership capabilities, deep technical skills, and ability to build world class teams, made him the ideal candidate to lead Shutterfly’s technology organization. Specifically, Neil will oversee the company’s web, products, services, and e-commerce engineering teams, internet operations, quality assurance, and program management groups.

Most recently, Neil was at Sears Holdings where he was responsible for architecture, technology strategy, and software development with an emphasis on e-commerce applications. Prior to Sears Holdings Neil held senior technology leadership positions at MediaMaster, Wal-Mart, Velosel, 3DO, and Apple.

So that summarizes our Q2 2009 accomplishments. I am pleased with our ability to deliver innovative products and services and strong financial results despite a tough economic environment. We believe 2009 will continue to be a challenging year for most Americans and for consumer spending. As we prepare for Q4, we will continue to execute against our stated goals of increasing our lead in the Photo Book, cards, and stationary and memory sharing markets and differentiate ourselves through the continuous innovation, design forwardness, customer friendly policies, ease of use, and high quality.

I am confident that the strong foundation we are building will help us to deliver increased revenue, free cash flows, and long term shareholder value. With that, I’ll turn the call over to Mark to review our financials in detail.

Mark J. Rubash

Thanks, Jeff. I’ll begin my comments today with some observations about our second 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 Q3 and revised full year 2009 financial guidance. Following that discussion, we’ll open the call for your questions.

At the risk of being repetitive, there’s no question that we continue to execute against the very difficult economic climate. While there have been some discussions recently of green shoots and a stabilizing economy, I don’t believe that there’s been any sustainable improvement in the fundamentals for consumers. Unemployment and gas prices continue to rise, consumer credit markets remain tight, and depressed home prices continue to limit funds for discretionary spending.

The net result of these factors is that consumers remain under considerable financial pressure and by necessity are focused on balancing their personal budgets through reduced discretionary spending. Given this challenging environment, we remain focused on executing our strategy and on maintaining our cost structure and capital investments in line with our revenue growth. This strategy has served us well through the first half of this year and is beginning to yield clear improvements in our product and service offerings and in the fundamental metrics that drive our business.

During Q2 our key engagement metrics continued to show the consistent trends we have seen for several quarters now with reduced activity during the non-gift giving periods, and stronger performance on the days surrounding the Easter, Mother’s Day, and Father’s Day celebrations.

For the full quarter site visits showed solid growth from the prior year and a modest acceleration from the growth rate we saw in Q1 of this year. More importantly, as a result of improvements in site design, merchandising, and our promotional strategy, the number of new user registrations accelerated significantly from Q1 and showed very strong double digit growth from the relatively strong second quarter of last year. The number of unique uploaders also showed healthy increases reflecting double digit year-over-year growth.

Finally, the number of image uploads and photo shares continued to grow at very healthy double digit accelerating growth rates. During Q2 we had nearly 950,000 transacting customers who generated over 1.65 million orders with an average order value of $23.09. This activity translated into 13% year-over-year growth in customers, 6% increase in orders, and 2% growth in average order value.

We’re very pleased to see the growth in customers and orders this quarter and the continued strength in AOV. We believe these results are further validation of our strategy to offer the most compelling assortment of products, services, quality, and value for customers in these large and growing markets.

Let’s now move through a discussion of our reported results starting with net revenues. Net revenues for the quarter totaled $38.9 million reflecting 10% year-over-year growth. The allocation of net revenues between new and existing customers was 21% and 77% respectively, consistent with Q1 and with our second quarter last year. Net revenues for the quarter also included $680,000 from our commercial print customers.

In terms of product mix, net revenues from prints and personalized products and services totaled 38% and 61% respectively, while net revenues from our commercial print initiative represented 1%. Also net revenues from 4 x 6 prints represented 22% of total net revenues down from the 28% revenue contribution in the prior year. In terms of net revenue growth rates, total print revenues declined 7% year-over-year, reflecting both a decrease in the ASPs for 4 x 6 prints that resulted from last year’s price change offset partially by continued stable growth in unit volumes.

Personalized products and services increased 20% year-over-year, led again by continued strong double digit growth in Photo Books and increase in contributions from our expanding line of designer cards and stationary.

Moving to cost of net revenues and gross margin, our Q2 gross margin was 48.4%, a 2.6 percentage point decline from the prior year, though well ahead of our expectations. Factors contributing to the year-over-year decline include loss of margin from lower 4 x 6 print prices and cost increases for our new Phoenix manufacturing plant which were partially offset by favorable product mix and continued leverage from shipping and materials costs.

Technology and development costs totaled $11 million for the quarter and included year-over-year increase of $229,000 for depreciation, amortization, and stock based compensation. Excluding these amounts are technology and development spending, increased approximately $900,000 or 14.6% from the prior year. The majority of this increase is attributed to cost increases for power, location space, and bandwidth. Our technology and development head count was flat year-over-year.

Continuing down the income statement, sales and marketing costs totaled $8.9 million for the year, representing 23% of net revenues, down slightly from the 24% expense level in the prior year. Excluding stock based compensation, sales and marketing costs represented 21% of net revenues down from the 23% of net revenues last year.

Our Q2 customer acquisition cost decreased about 8% from the prior year, reflecting continued improved performance from our search engine optimization efforts and from greater promotional efficiency. General and administrative expenses totaled $8.3 million in Q2 or 21% of net revenues compared to $7.6 million and 21% of net revenues in Q2 of last year. Excluding stock based compensation, Q2 general and administrative expenses totaled $6.9 million and were essentially flat with the prior year. On a year-over-year basis, total G&A expense reflects lower costs for outside consultants and contractors, offset primarily by increase for office space and legal expenses.

Continuing the discussion, adjusted EBITDA for Q2 totaled $200,000, far better than our guidance which ranged from a loss of $1 million to a loss of $3 million. This EBITDA improvement resulted from continued efforts across the company to manage our cost structure in line with our revenue growth and further demonstrates our commitment to deliver increasing profitability and free cash flows.

The quarterly effective tax rate was 38% compared to our guidance which ranged from 40% to 67%. The lower rate assumption is attributed primarily to improved full year profit expectations as well as increased research and development credits. 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 in either pre-tax income or permanent tax differences.

On a GAAP basis, our net loss for the quarter totaled $5.7 million or a net loss of $0.22 per share. On a non-GAAP basis, the net loss was $3.5 million or $0.14 per share. The shares used to compute the quarterly net loss totaled 25.2 million.

Now I’d like to provide some additional details on our capital expenditures and on our cash investment and liquidity status. Capital expenditures during the quarter totaled $2.9 million which included $900,000 for technology equipment and software, approximately $900,000 for building improvements and manufacturing and office equipment, and $1.1 million in capitalized software development costs.

Cash and liquid investments at June 30 totaled $63.3 million. In addition, we continue to carry investments in auction rate securities with a fair value of $45 million which reflects a total impairment of $7.2 million. At June 30 approximately 70% of the principal amount of auction rate securities were AAA rated and 30% are now AA rated. In addition, we continue to receive all interest payments on schedule.

Our balance sheet at June 30 also reflects a long term asset totaling $7.2 million which represents the estimated fair value of the UBS right which is exercisable beginning on June 30 of next year.

Finally, on June 29 we established a 364 day $20 million line of credit facility with Silicon Valley Bank to supplement our available cash and liquid security balances. We continue to believe that these resources are adequate to meet our current and future operating cash requirements.

I’d now like to summarize our outlook for Q3 and updated outlook for the full year 2009 together with some additional insight on our underlying assumptions. The complete details of our updated 2009 financial guidance are included in today’s press release.

While we continue to make progress on our strategy and are pleased with our financial results for the first half of this year, we believe that the recessionary pressures on consumers will continue to represent a challenge for our business. In addition, with no gift-giving holidays during Q3 and more than 50% of our full year revenues expected to come from Q4, our quarterly and full year top line results are difficult to predict. Accordingly, we continue to be appropriately cautious with our revenue guidance.

In terms of the components of net revenues, we expect to see the continued trend of weak non-seasonal order volumes with modest year-over-year increases during the traditional seasonal shopping periods. We expect a consistent mix of revenues between new and existing customers with modest growth in average order values.

Finally, we expect a continued shift to revenues from 4 x 6 and other print categories to or 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 increasing number of new customers.

During Q2 we generated approximately $680,000 in commercial print revenues and we’ll work to build on that amount through the remainder of 2009. I would also like to note that our commercial initiative is still early in the business development phase and that we do not yet have sufficient order volumes to provide a reliable revenue forecast. As a result, we are not providing any commercial revenue guidance for 2009 but will report our progress to you each quarter.

In terms of our cost structure, with a number of new product launches scheduled for the balance of the year combined with a strong holiday marketing and promotion plan, we will begin increasing our sales and marketing spend during Q3 and extending well into the peak Q4 holiday season. These planned cost increases are reflected in today’s financial guidance.

Finally, while we remain firmly committed to our plan of increasing profitability and free cash flow, in the event that net revenues fall to the low end of our updated 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’ll now summarize our revised guidance for 2009 starting with the full year. We now estimate that net revenues will total between $205 million and $220 million reflecting a year-over-year decline of approximately 4% to year-over-year growth of approximately 3%. Please note that these amounts exclude any additional 2009 net revenues from our commercial printing initiative. We expect the full year GAAP gross margin to range from 51% to 53% of net revenues and our non-GAAP gross margin to range from 52% to 54% of net revenues.

The year-over-year decline is attributed primarily to margin loss from 4 x 6 print pricing and 2009 costs for severance and the transition to our new Phoenix manufacturing plant. We expect that your full year 2009 EBITDA margin will range from 14% to 18% of net revenues. In addition, we now expect that 2009 capital expenditures which include capitalized product development costs, will range from $20 million to $22 million. Using the midpoint of this updated guidance, we expect 2009 capital expenditures will now range from 9.4% to 10.4% of net revenues, a solid improvement from the 10.7% level incurred during 2008 and clear confirmation that our strategy of selectively outsourcing peak manufacturing demand and closely managing our technology spend is beginning to pay off.

Turning now to Q3, we expect net revenues to range from $34 million to $36 million which reflects a year-over-year decline of approximately 4.6% to an amount in line with our Q3 2008 results. Please note that with no gift giving holidays during Q3, net revenues could be down sequentially from Q2 2009 levels which benefited this year from the inclusion of the Easter holiday period.

We expect our GAAP gross margin to range from 45% to 47% of net revenues and our non-GAAP gross margin to range from 47% to 48%. Primarily as a result of the planned increases to our sales and marketing spend described earlier, we expect our adjusted EBITDA will range from a loss of $3.5 million to a loss of $2 million.

In summary, in light of the continued uncertainty and challenges presented by the current economic environment, we believe that our Q3 and revised full year 2009 net revenue and profitability guidance is appropriately cautious and reflects the significant uncertainty in today’s marketplace.

So with that I thank you for your time today and look forward to speaking with 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) Your first question comes from Kristine Koerber – JMP Securities, LLC.

Analyst for Kristine Koerber – JMP Securities, LLC.

We’ve been hearing that one of your competitors has been testing a free shipping promotion on orders over $4.99 and that it may become permanent. Could you comment on this and what it may do to the competitive environment and would you ever consider doing something along those lines, then secondly, could you talk about the percent of business you plan to outsource for this holiday and eventually how much you believe that you can ultimately outsource and then lastly could you provide an update on any initiatives you are working on to grow the business internationally.

Jeffrey T. Housenbold

As it relates to free shipping across e-commerce it’s clearly a promotion that resonates with customers and we have historically run free shipping promotions, often with hurdles of either $25, $30, or $50 throughout the gift giving seasons with an emphasis in the fourth quarter. We’ll continue to test a variety of different promotions driving different business results from trial to repeat to up sell and cross sell and continue to optimize within our business and we think the success we’ve enjoyed over the last few years is positive proof that mix is working.

As it relates specifically to competitors, we can’t comment about what their strategy or what they’re doing. When you’re a distant third in the industry, you’re going to deploy a much different approach to try to capture share and we think growing the top lien as well as continuing to increase free cash flow is the right strategy for us.

As it relates to outsourcing, the strategy we deployed in the fourth quarter of 2007 in outsourcing some of our excess demand in those peak periods to some strategic outsourcing has proven very successful in allowing us to reduce capital expenditures and increase free cash flow, so we’ll continue to do that. We’re not prepared to give a specific percentage but to date we haven’t outsourced cards or Photo Books where we have a demonstrable quality differential in the binding and the complexity of those products makes it more difficult to outsource but we’ll continue to look for additional ways to gain efficiencies and now capital expenditures.

As it relates to international, we continue to look at opportunities to expand the Shutterfly brand globally. We think the demand for our products and services is a global one, it’s a humancentric one, to share and preserve life’s memories, so we continue to look at opportunities to do that and what the appropriate investment against the [har biston] and reward and the impact to the P&L so no specific update as it relates to international today but it is an area of opportunity for us and an area we’ll think we’ll allow to continue to grow the size of the franchise.

Operator

Your next question comes from James Friedland - Cowen and Company.

James Friedland - Cowen and Company

First, if you could just give some insight into how Easter impacted the quarter on a year-over-year basis and to shift it from Q1 last year to Q2 this year. What do you think your revenue growth would have been if you took Easter out of the mix. Secondly, on marketing, you noted that customer acquisition costs were down 8% year-over-year and you’re also talking about increasing advertising as you get into Q3, Q4. Is this sort of the traditional ramp that you always do in Q3, Q4, or is there anything incremental that you’re doing this year that might layer on more costs in light of the fact that you’re gaining efficiencies on customer acquisition costs.

Mark J. Rubash

With regard to Easter, what I will say, I’m not going to be able to quantify the percent of revenue that came from Easter. What I will say is that we definitely saw the seasonal kind of spike in order and activity across that period as well as the Mother’s Day and Father’s Day periods and I would say this quarter with those holidays, in past quarters we’ve probably seen slower activity during the in between times. We did see some lift during the in between periods in 5% to 10% types of growth in metrics during those key holiday periods. So clearly Q2 benefited from Easter but it’s not the types of numbers I think that would cause a change in view or anything other than putting it into your model for an increase for that week and a half period of activity.

In terms of the marketing spend, clearly on the customer acquisition, the direct spend, we had really strong growth in registrations this quarter and a lot of that translated into new customers pulling down our direct costs of acquisition, probably one of the lowest levels we’ve seen in a number of quarters. Having said that, we’re also following a pretty consistent approach of really trying to put as much of our marketing resources into the periods customers are going to be inclined for gift giving and that’s why we pulled back a little bit in Q2. Those are very natural holidays, but end of Q3 going into Q4 is when we will be deploying more robust type of spending but in terms of full year where we see total marketing spend, I don’t expect any significant change from where we’ve been historically, just greater concentration in the key holiday periods, and perhaps a little bit richer mix to the online media channels.

Operator

Your next question comes from Youssef H. Squali - Jeffries & Company, Inc.

Youssef H. Squali - Jeffries & Company, Inc.

Mark, if I look at the AOVs over the last three years, Q1 and Q2, they’ve been flat to up. In this period they were down even though the mix of print and personalized product continues to go in the right direction obviously towards personalized products. My understanding is that generally speaking , personalized product carried a higher [alias] so just trying to reconcile that, if you can help us with that. Then maybe Jeff, following Kodak you’ve changed, we’ve seen a kind of a nice bump to your traffic. I was wondering if maybe you can help us maybe not quantify because you won’t do it but maybe just qualify the impact that you’ve had from that maybe [intra] quarter and really to that, what is the profile of these customers just in terms of kind of usage, conversion, stuff like that.

Mark J. Rubash

So on the first one, AOV, I said many times that over the long term this is a metric that absent the introduction of substantive new products, it’s a metric that we expect to kind of grow at a relatively slow pace over time. On a quarter by quarter basis, it’s impacted quite a bit one by product mix, and two the type and level of promotions that we do and the uptick on those promotions. One of the things that we did in Q2 was a fair amount discounted and free products to increase awareness in a number of the personalized products. That has an impact of increasing awareness substantially which we think will make a big difference as we go into the Q4 holiday season but in the interim basis, it will cause the AOV to fluctuate, so I’m not concerned about the fluctuation last quarter this quarter. I tend to look at where we are long term on the products and what the ASP on those products are and we’re seeing a consistent healthy trend in ASP across all the SKUs.

Jeffrey T. Housenbold

As it relates to I think you were speaking about Kodak’s decision to charge people for storage, otherwise they would delete their photos and what the impact of that has been to us, hard to quantify specifically. I think we really look at it from a portfolio perspective of “How do we differential ourselves from the market palace” and certainly our customer friendly policies of no compression, no downsampling, no forced deletion, no forced registration, 100% satisfaction guarantee. Those things have always been part of the Shutterfly brand and our brand equity and allow us to continue to acquire customers at a fairly low CAC. That combined with our quality and ease of use of design forwardness and now innovation, are really good things that are part and parcel of our strategy that we’ll continue to push upon As competitors react and try to catch us as we try to extend you lead, they’re going to do different things that will impact our business and I think we’ve had a modest benefit from Kodak’s decision in doing that and we certainly got a tremendous amount of PR benefit from that, but it’s not something we’re overly focused on as it relates to our response or our metrics. I think really just executing against our strategy, so in summary, in the quarter I think it had modest impact and will continue to have a modest impact but it’s really part of a larger portfolio with brand differentiation.

Mark J. Rubash

Youssef H. Squali - Jeffries & Company, Inc.

Do these customers have a different profile than Shutterfly’s typical customer?

John A. Kaelle

It’s hard for us to determine that because we don’t know if you were a Kodak customer before or not when you signed up for Shutterfly. What we did see was healthy 13% increase in customers this quarter, 6% increase in orders, and so part of that increase in customers was probably from Kodak’s decision but a lot of that was from our promotional strategy and our business development relationships and now our social and viral media campaign.

Jeffrey T. Housenbold

I would just add to that, when you look across the linearity of business activity weekly across the quarter, the [inaudible] pronounced changes were centered around the gift giving holidays, Easter, Mother’s Day, and Father’s Day, and certainly less so around the period of promotion, we ran at the time of Kodak’s change.

Operator

Your next question comes from Imran Khan - JP Morgan Securities, Inc.

Imran Khan - JP Morgan Securities, Inc.

Question number one, if I look at your first half revenue growth is 7% on a year-over-year basis, even if I add just for commercial printing I believe it grew mid single digit. But for the full year you’re guiding revenue growth of negative 4 to positive 3. Are the comps just getting easier? I’m trying to understand if you’re seeing anything in the quarter that is suggesting that the revenue growth will be much worse than first half of this year, this by easier comps. And secondly, I think with the expanding of facilities in Phoenix, Arizona, won’t you expect some gross profit margin improvements from there? I think the first half of this gross profit margin is impacted by that but I think the Q3 you were guiding flat to down slightly, so I’m trying to get a better sense, when do you expect to see benefit from that?

John A. Kaelle

On t he revenue first, I’ll start with just reiterating what I’d said in the opening comments, that we continue to be very cautious with our revenue guidance. There’s something in this current economic environment where kind of the sentiment of consumers and their ability to spend can change very rapidly, so one, we don’t want to get too far ahead of ourselves, and then the second part of your question, is there something in Q3? We’ve had a month of Q3 to look at and the main issue is that there’s no gift giving holidays in Q3 so every dollar of revenue, you really have to work for it and the level of activity, and we’ve seen in July, it’s pretty consistent with what we’ve seen in other previous non-gift-giving periods. So that’s why I think Q3 may or may not be an indicator with respect to Q4 but I do think it’s going to be a challenge to grow sequentially versus Q2 which this year benefited from having Easter included.

Jeffrey T. Housenbold

As far as gross profit goes, our cost structure is essentially in line with Q2. The major changes are if you look historically because of a seasonal mix shift that happens every Q3, we get richer on the print side of the equation. If you go back the last 3 or 4 years, every year in Q3 the gross margin has been about 2 percentage points lower than it was in Q2 so part of the guidance just reflects that expected seasonal shift in Q3 to a higher mix of print related products.

Then the second is that late in the quarter we started doing some ramp up with bringing on early stages of temporary help and training as we get ready for Q4. As far as where the benefit from Phoenix, the largest benefit from Phoenix comes from lower labor costs and that’s going to have its biggest impact in Q4 when we have our really most significant blend of higher labor content products like Photo Books.

Operator

Your next question comes from Mitchell Bartlett - Craig-Hallum Capital.

Mitchell Bartlett - Craig-Hallum Capital

Just following up on that last question, the gross profit margin and the sequential, that was good guidance to understand the drag from print Q2 to Q3 and the gross profit margin, but did you say in the script and did I miss what was the transition cost expenditures in the gross profit margin in Q2, and a separate question on print, did you also quantify 4 x 6? You said there was good volume gain. Do we annualize that completely, the pricing on decline in Q3 and what was the volume gain in Q2?

John A. Kaelle

So on Q2 transition costs, I didn’t disclose in the script but they were in the $500,000 or $600,000 in Q2 in terms of the kind of final ramp up training and scrap getting those different production lines in stream. So there is some amount of cost related to Phoenix that are no longer recurring so from a transition standpoint, Q3 is fairly clean with Phoenix but there will be additional either rental or depreciation of equipment as we gear up for Q4 and then the start up some training with the onset of seasonal labor cost so I would say the transition cost we saw in Q2, about the same in terms of ramp up costs in Q3.

In terms of 4 x 6 print pricing, the change went in effect in the middle of September of last year although we were doing a fair amount of discounted test pricing earlier than that so Q3 is not a perfectly even comp but it’s more even than Q2. As far as the unit volumes, we’ve seen very consistent with where most of the industry forecasts are and forecasts in 4 x 6 unit volumes. Q2 unit volumes are actually healthier than they’ve been in a while so it’s still an important part of our business, it’s still a product that consumers pursue but long term we still believe that transition from 4 x 6 into the personalized products will continue on the pace it has been on.

Jeffrey T. Housenbold

Just to add to that, I think the key… we’re getting enough information due to math but we grew in very high single digit growth rates on the unit basis for 4 x 6 prints yet we still have the premium pricing strategy in the marketplace and I think that’s important to keep in mind as there are always cheaper places to get many consumer goods but it’s the total value proposition to the consumer in terms of our customer friendly policies, our designs, our ease of use, the physical product choices across our Photo Book line, and so we think all that and the type of customer we attract relative to some of the other competitors, they are less price sensitive and more value driven and that allows us to capture more margin that we continue to reinvest into expanding and diversifying the product line.

Mitchell Bartlett - Craig-Hallum Capital

Separately on customer acquisition costs being as favorable this quarter as you’ve seen it in a number of quarters, and we know that there was some good competitive progress against Kodak and what not, but share sites, you talked about that, 1.2 million share sites, the good sequential and helpful on customer acquisition. Just how important was that not only on customer acquisition but I know it’s early days in this but the traction you’re having on it on an e-commerce basis on the share sites, then a second question would be on product launches, new product launches you talked about in the script. What might those be or is there something big coming or just expansion of existing portfolio?

John A. Kaelle

The share sites continue to be an important part of our strategy and one of the key three strategic initiatives for us as it was when we pioneered online photo sharing in ’99 and then updated that to be more relevant in a social networking world with our share sites. We’re very pleased with the growth there. If you look at a proxy, I think [Named] which is a private company just announced that have 1.2 million share sites as well and they just raised their last round at $750 million valuation, so if you think about a piece of our overall business relative to some comps out there, we’re doing very well with that.

Our goal obviously with share sites is to acquire customers, get them to purchase from an e-commerce standpoint, and then eventually, we’re still in the early days, is we continue to invest in our sponsorship and advertising basis. It allows us to monetize those users who are not purchasing and then further monetize those that are. So the early days still on e-commerce as we integrate that into share sites is going well. The customer registrations and acquisitions through share sites have exceeded plan and part and parcel of the 13% growth in customers we saw. So we’ll continue to invest in that platform which our customers have seen as very favorable and also another key differentiator for us.

The new product launches I think that standout has been our continued investments in stationary and the card line throughout the year as we added to brides and new babies and non-photo based stationary for dinner parties and gradations. We’ll continue to invest in that business and that is growing quite nicely. Then as it relates to what else is doing to come this year, for competitive reasons, I won’t talk about specifics, but we think that we’re very, very early in these markets that they’ll be a lot of continued innovation over the next few years and ways that people can utilize their digital content, combine that with community and professional content, tell their story, and connect with people.

So we’re going to continue to be at the forefront of that booked on a physical product standpoint, but also on a digital standpoint such as our recent opening of the platform to allow people to integrate into Twitter and Facebook and other blog sites so we’re excited about the product road map for the rest of this year but even more excited about what 2010 is going to bring.

Operator

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

Alan Gould – Natixis Bleichroeder, Inc.

Can you tell me what percentage of your orders are currently being sent with free shipping right now, and secondly, where is your efficiency on the Arizona plan compared to the east coast plant. Are you at the same efficiencies yet or will that take to the fourth quarter when you’ve got all the training and everything finished?

John A. Kaelle

We won’t give out the specific percentage but from time to time throughout the quarter we were running different free shipping promotions with different hurdles and as low as $20, $25 for that hurdle, so a significant proportion, more than a majority, more than 50% of sales during those promotional periods actually went out with free shipping. That was partly what led down AOV but it was also what helped us acquire new customers. So we think that was the appropriate blend to get people into t he franchise and also to get our existing customers to try a Photo Book and to see how that is a much better format than just simply 4 x 6 prints.

Keep in mind less than 35% of our existing customers have yet made a Photo Book so we think there’s a lot of penetration left of our house list if you will not only less than 15% of the entire addressable market has tried a Photo Book, so we’ll continue different promotional campaigns, Buy One Get One Free, do something, get one free. We do things on a business development standpoint where we help our partners differentiate themselves with a free gift with purchase, so we’ll give out free Photo Books in contextually relevant ways and we’ll continue to try that along with free shipping at the appropriate levels. We do think our hurdle is the right way to go and I think it allows us to preserve the margin and still offer a competitive price point and competitive service relative to those that are offering free shipping.

Jeffrey T. Housenbold

In terms of manufacturing, plant efficiency, a couple of things to keep in mind. One, the Charlotte and Phoenix plants are as close to carbon copies as you could possibly imagine. They are both 100,000 square foot facilities. They are managed centrally by the same team. The main difference right now is that the team actually running the production is an almost entirely new team so they’re kind of going into their second quarter of manufacturing products for Shutterfly and that I’m sure will improve what time.

Second is they’re not running all the same products that Charlotte is currently but they will be by Q4 and then lastly, a lot of the leanings from a lay out and production work flow, a lot of the efficiencies that were developed at Charlotte were actually applied t the very beginning of Phoenix, so we actually expect that the benefits were certainly relative to Hayward will result in much faster and so far that entire project, I take my hat off to that entire team, has been on time, under budget, and really we can’t tell the difference between one plant and the other. It’s working extremely well.

Operator

Your next question comes from Michael Olson - Piper Jaffray.

Michael Olson - Piper Jaffray

Just the mix shift towards personalized products is clearly ongoing. Is there a target that you’d be willing to share for personalized product as a percent of revenue in 2009 and 2010 and second, do you have any metrics on average order value of new customers versus return customers and if you do, how have those metrics been trending?

John A. Kaelle

As it relates to mix shift, we haven’t given specific targets and we won’t do so today but we do believe you’re right, that trend has been in place for quite some time. We have said we believe it will continue to do so. We don’t think prints goes to zero. And from a profit and contribution standpoint, prints are still a good business for us, but we do think the ability to tell your story with the richness of our award winning Photo Books is starting to resonate with customers and our biggest challenge isn’t really the competitive environment, it’s really just simply awareness of the category.

So many people don’t even know you can make these and when you see them, they have this tremendous wow factor and so our job through our marketing, through our viral word of mouth, through our partnerships is really to build awareness of the entire category because we’re confident that the service we provide, the ease of use and creation and the designs in the physical products stand out against the competition, so as that pie gets bigger we believe we’ll continue to be able to grow or franchise.

It’s not just the Photo Books. We’re seeing a mix shift from going to your retailer, drug store, to buy a generic greeting card and really wanting to personalize and make something unique as you think about social expression and communication with people across a variety of different occasions and holidays. So traditionally the vast majority of our card business has been fourth quarter holiday but with the recent introduction to baby and wedding and save the dates and graduation, we’re trying to capture more of that every day card giving business which is about 65% of the overall greeting card business in America. So continue to expect that mix shift, that’s where our investment is, that’s where our marketing message is, that’s where the layout of our site is driving out customers but no specific targets today.

Michael Olson - Piper Jaffray

In terms of average order size, we have seen over the past few years new customers coming in at very close if not exceeding the average order size for existing customers. If you go back three or four years, a lot of the new customers would come in and start with a very simple product, maybe one that involved a single picture or ordering prints and maybe weren’t quite ready to take on a project like a Photo Book. Today that’s not the case at all and you actually see virtual parity in the average order size for new and existing and in some quarters, including this one, the average order size for new customers is actually slightly higher than existing. So I think one, it’s a testament certainly to the product and marketing teams and their efforts to educate and bring awareness to the customers but also in the creation paths and all of the tools we’ve made available to help make the creation process for Photo Books easier so we’re very pleased with where it’s going and I would call… they’re at parity today.

Operator

With no further questions in the queue, I’d like to turn the conference back to Jeff Housenbold for any additional or closing remarks.

Jeffrey T. Housenbold

Thanks everyone for joining us today. In summary, we’re very pleased with our performance in Q2 and my hat goes off to all the employees here at Shutterfly who continue to listen to our customers create innovative new products and services and execute with extremely high quality. While we focus quarter to quarter, the team and the company are really focused on a much broader and longer time horizon as there is a continued shift and a desire by customers to utilize their own content in a digital way to create interesting and innovative products to stay connected, preserve, and share their memories. We think we’re at the earliest days of these very, very large multibillion dollar industries and we’re at the forefront of that from a physical product standpoint and from creating a permission based way to share your content across the internet and with those that are meaningful to you. So we’ll continue to make the investments against Photo Books, cards, and stationary and share with the focus on driving both top line results and increasing free cash flow as we go throughout 2009 and beyond.

We look forward to updating you guys on our next call. Thank you.

Operator

Once again that does conclude our conference for today. We thank you for your participation

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Source: Shutterfly, Inc. Q2 2009 Earnings Call Transcript
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