Shutterfly, Inc. Q3 2009 Earnings Call Transcript

| About: Shutterfly, Inc. (SFLY)

Shutterfly, Inc. (NASDAQ:SFLY)

Q3 2009 Earnings Call

October 28, 2009 5:00 pm ET

Executives

John Kale – Vice President, Finance

Jeffrey Housenbold – Chief Executive Officer

Mark Rubash – Chief Financial Officer

Analysts

Kristine Koerber – JMP Securities

Imran Khan – J. P. Morgan

[Navid Khan] for Youssef Squali – Jefferies & Company

Mitchell Bartlett – Craig-Hallum Capital

Shawn Milne – Janney, Montgomery Scott

[Kevin Koppleman – Cowan & Company]

Michael Olson – Piper Jaffray

Operator

Welcome everyone to Shutterfly’s third quarter earnings conference call. This call is being recorded. I would now like to turn the call over to John Kaelle, Vice President of Finance for Shutterfly.

John Kaelle

Welcome to Shutterfly’s third quarter 2009 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 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 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 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 of today. This presentation contains certain financial measures that are different from financial measures calculated in accordance with GAAP and may be different from calculations that measures made by other companies. The quantitative reconciliation of these non-GAAP financial measures to the most comparable GAAP financial measures is available on our Q3 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 Housenbold

Welcome everyone. Our objective today will start with the review of our Q3 2009 performance. Then I’ll turn the call over to Mark to review our Q3 financial performance in detail and to provide financial guidance for Q4 and the full year 2009. We’ll then open up the call for Q&A.

So let’s get started. Shutterfly delivered solid third quarter results. Q3 marked our 35th consecutive quarter of year over year revenue growth and we delivered the top line with better than expected margins. We continued our focus on innovation, execution, and Q4 preparedness across all facets of the business which drawn alignment of top three strategic imperatives; increasing our photo book, card and stationary and memory sharing businesses.

Now I’ll briefly recap some of our progress starting with our product and then turning to our services, marketing and commercial printing efforts.

Starting with Photo Books, we saw continued increases in awareness and adoption during Q3 as a result of our strong mix of marketing and promotional programs along with the launch of our new Simple Path Photo Book creation process.

By reducing the time, effort and price of creating a Photo Book, we believe that Simple Path will be a key tool in engaging a mass audience to experience the wow effect that comes from having your story told in a professionally bound, coffee table quality Photo Book. With Simple Path, we can now offer Photo Book that takes less than five minutes to make for under $15.000.

It is this kind of innovation that will continue to differentiate Shutterfly in the market place and drive increased first line product and services revenue.

Simple Path automatically creates a Photo Book in one click. Our smart algorhythym instantly organizes and arranges photo’s into a Photo Book that look professionally designed. Consumers can order as is or further personalize their book in just minutes using 21 exclusive style templates and easy to use editing tools.

Users can simply order the book or change the book size and cover type, rearrange photos and pages and add captions. Simple Path Photo Books can accommodate between 20 and 400 photos and are available on all five Photo Book sizes; 5 X 7, 7 X 9, 8 X 8, 8 X 11 and 12 X 12 starting as low as $12.99.

For Photo Bookers who want more options and control, they can still choose our award winning custom photo book experience which we updated with new styles and backgrounds. With thousands of layout and design options, the custom pack gives users the ability to build their book page by page and features more advanced editing and storyboarding tools, expanded space for text and journaling and includes more than 50 style options for endless creating possibilities.

All Shutterfly Photo Books can be shared with friends and family via Shutterfly’s popular share site and social networking and blogging sites like Face book, My Space and Word press. Custom pack and digital scrapbooks can also be uploaded to Shutterfly’s gallery.

Now turning to cards and stationary, during the quarter we made significant enhancements to our rapidly growing cards and stationary collection in preparation for the peak Q4 selling season. For example, we refreshed our collection by adding more than 800 new holiday designs, improved our 5X7 greeting cards by adding the ability to include images, graphics and text in multiple layouts inside the cards, extended our direct mail service where we address and mail customer’s cards directly from our manufacturing facility, launched attribute based filtering to help customers find the right card type and style, added a new cross sell functionality to showcase related products such as thank you cards and gift tags, and partnered with five needy charitable organizations to create unique and exclusive holiday cards that provide our customers and their donors with a stylish way to express themselves while supporting these important causes.

Our 2009 partners include the American Lung Association, Kemper International, Live Strong, Special Olympics and the World Wildlife Fund.

Rounding our Q3 product enhancements, we added new center stage products and puzzles featuring Star Wars, GI Joe and characters in time for Q4 gift giving season. We partnered with both Nickelodeon TV and K-Mart to promote the Dora posters to their customers.

Now let’s review our progress at Shutterfly by services and overall user experience starting with our shared sites. As a reminder the goal of Shutterfly shared 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 share platform combines the power and benefits of photo and video sharing while 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 site’s adoption continues to be strong. We ended the quarter with more than 1.5 million sites and more than 376 million photos posted, up from 1.2 million share sites and 271 million photos posted in the most recent quarter.

During the quarter and in time for the fall sports season, we launched our new sports share sites. Our goal is to make it easier for players, parents and coaches to have the best organized, most engaged and memorable season possible. Our new sports share sites provide an integrated solution that allows teams to gather and share pictures and videos from everybody in a single secure place online, easily coordinate the logistics including team roster, player availability, snack planner, plays of the game and maps to the event, communicate the latest team updates and changes in real time email updates with minimal efforts to parents, players and coaches.

And, it creates high quality ways to share the memories and enjoy the season through our Photo Books and Photo gifts.

To increase awareness and adoption of our new sports share sites, we partnered with a number of the leading national and regional youth soccer, football and cheerleading organizations. More than 15,000 new sport sites were created during the quarter and the feedback from parents, coaches and the press has been very favorable.

During Q3 we enhanced our video service which we launched in partnership with Motion Box in June of this year. Shutterfly users can now upload videos to a dedicated My Video’s page within their account where videos can be watched, shared, renamed and deleted. In addition to being able to post videos to share sites, Shutterfly video users can send video email shares and post videos to Face book right from their Shutterfly account.

In early April, we launched our first application for the I-phone and I-pod which were downloaded by more than 300,000 users. Based upon user feedback, we updated our I-phone application during the third quarter. Some of the new enhancements include the ability to download pictures in your account to your I-phone, email them to any I-phone contact, assign them to a specific contact so the pictures appear when they call your phone and post photos from their Shutterfly account to share site all while on the go.

During the quarter, we also acquired Tiny Pictures; adventure backed San Francisco start up which developed leading edge photo and video applications for mobile and social platforms. The nine people have joined Shutterfly and is working on some new and exciting I-phone applications that will engage new and existing customers in unique ways.

Additionally we made several user experience and site performance improvements. Last quarter we updated our home page, registration pages, and promotional engine. During Q3, we redesigned our store front and top level navigation to increase awareness of our unique first line products to increase conversion rate and to improve our national search rankings.

We also enhanced our CRN capabilities to offer one to one promotion triggered by user’s specific actions while on the site.

That summarizes our progress on products, services and user experience. Now, I’ll briefly cover some highlights from our marketing and commercial printing efforts.

During the quarter, our integrated marketing efforts were primarily focused on increasing the awareness, trial and repeat purchase of our Photo Book and card and stationary products and in supporting our new Sports share site launch.

We did this through extensive PR and co-marketing partnerships. For example, we partnered with Orbitz for our summer travel promotion featuring a dream vacation sweepstakes and with Diapers.com, Family Builder, Orbitz, Trip Advisor and Cozy to support our simple path launch.

We also expanded our presence on Face book and Twitter where our fan base is approaching the 40,000 mark and leveraged our strong relationships with blog and social media influencers to grow awareness of our holiday product offering.

Lastly, just a week ago, we launched the Shutterfly blog Picture More, a destination for inspiration, tips and tools for new and existing Shutterfly users. In order to drive awareness and increased customer acquisition early in the holiday season, we designed several direct to consumer programs.

We’ve expanded our photography program to include more than 300 malls across the United States. On November 7 Shutterfly customers will host more than 1,500 house parties simultaneously across the country where friends and family will test and create Shutterfly’s Simple Path book creation experience.

Party guests will receive a free 7X9 Photo Book and get exposure to our holiday card collection and holiday card catalog. These programs are incremental to our usual online and offline advertising efforts.

Now let’s turn to our commercial printing initiatives. During Q3, we made continued progress building our commercial printing business. The team delivered $1.2 million in revenue up from $680,000 in Q2. During the quarter we had 14 different clients of which eight were new customers.

We are pleased with our progress, particularly in the macro economic climate and 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.

Lastly, in Q3 we were pleased to announce that Brian Sweeney joined Shutterfly’s Board of Directors. Brian was previously Chief Operating Officer at EBay and the Chief Marketing Officer at Pepsi Cola. With deep experience in global marketing, strategy and business operations, and his Board experiences with consumer R&T companies such as Burger King, J-Crew and FRS will be a valuable resource as Shutterfly continues to grow.

So that summarizes our Q3 2009 accomplishments. I am pleased with our ability to deliver innovative products and services and strong financial results at the top and bottom line despite a tough economic environment.

Looking towards the holiday selling season, I believe that in my five years at the company, that this year, we are best prepared for a successful fourth quarter in terms of site experience, product assortment, design choices and manufacturing capabilities. Our fantastic line up of holiday cards with hundreds of designs, new form factors and improved shopping experience of Photo Books in a broad array of sizes and designs and the new option of having us make the book for you using our new Simple Path creation process.

Our integrated multi-channel marketing campaign and our fully operational owned and operated manufacturing and fulfillment centers positions us well for the fourth quarter. I am confident that if we continue to differentiate ourselves in the market place through innovation, design forwardness, customer friendly policies, ease of use, high quality and solid execution, we will be able to maintain our track record of 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 Rubash

I’ll begin my comments today with some observations about our third quarter performance followed by a review of our key metrics and then a walk through of this quarter’s operating results. I’ll conclude my comments with an overview of our Q4 and revised full year 2009 financial guidance. Following that discussion, we’ll open the call for your questions.

So let’s get started with a review of our top level metrics. During Q3, our key metric continued to show the trends that we have seen for several quarters now with steady growth in non-transaction site activity and more modest growth in customer’s orders and average order value.

In Q3, site visits showed a healthy year over year increase and a sequential increase consistent with our historical seasonality. More importantly, with continued strong contributions from our share platform and benefits from recent improvements in our site design, merchandising and promotional strategy, the number of new user registrations continued to show solid double digit year over year growth.

And finally, the number of unique uploaders, image uploads and photo shares all continued to grow at very healthy rates.

During Q3, we had nearly 982,000 transaction customers who generated over 1.7 million orders with an average order value of $23.03. This activity translated into 7% year over year growth in customers, 3% increase in orders and a 6% growth in average order value.

We’re very pleased to see the continued growth in customers and order volume this quarter as well as the consistent strength in average order value. We also 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 to a discussion of our reported results starting with net revenues. Net revenues for the quarter totaled $40.5 million reflecting 13% year over year growth. The allocation of net revenues between new and existing customers was 21% and 76% respectively consistent with Q2 and our third quarter last year.

Net revenues for the quarter also included $1.2 million from our commercial print customers, a sequential increase of approximately $500,000 bringing the year to date total to $2.6 million.

In terms of product mix, net revenues from prints and personalized products and services totaled 39% and 58% respectively and commercial print revenues represented 3%.

Net revenues from 4X6 prints represented 24% of net revenues in Q3, down from the 29% revenue contribution in the prior year. In terms of net revenue growth rates, total print revenues declined 6% year over year reflecting both a decrease in the average selling price for 4X6 prints resulting from last year’s price change, offset partially by continued and stable growth in our 4X6 unit volumes.

As many of you have likely noticed, one of our long time competitors has been trialing a series of limited storage policies, price changes, promotional offers and other give aways in an effort to increase their transaction volumes. This type of low cost, low service strategy is not new in the industry and we don’t expect the current differences in pricing will cause any noticeable change in either customer demand or our relative market shares.

More importantly, we believe that our consumer friendly policies, world class quality and clearly differentiated products and services will continue to represent a strong value proposition for all current and future Shutterfly customers.

Moving on to personalized products and services, net revenues increased 22% from the prior year led again by continued strong double digit growth in Photo Books and increasing contributions from our expanding line of design cards and stationary.

Photo Book unit growth was the strongest we have seen this year, reflecting increased adoption of our newest form factors and cover options. In addition, our new and expanded line of cards and stationary are already showing positive signs as we enter the Q4 holiday season.

To conclude my revenue discussion, I’d like to comment on the nature and extent of our referral fee arrangement with Web Loyalty, a major provider of online customer reward services. We, like many other e-commerce companies have offered a post transaction customer loyalty program that generates referral fees for each customer enrollment.

Since adoption of the program in Q4 of 2006, total annual referral fees have approximated 3% or less of our total net revenues and have been included as a component of personalized products and services. For 2009 we expect total referral fee revenues will decline to approximately 2.5% of net revenues and expect a further decline in 2010 to approximately 2% of total net revenues.

And finally, while the net margin from referral fees has contributed to our overall profitability and free cash flows, the annual amounts have been relatively consistent and have not significantly impacted the improving trend in EBITDA profitability.

Moving now to cost of net revenues and gross margin, our Q3 gross margin was 47.1%, a 1.6% decline from the prior year, though well ahead of the our expectations. Consistent with Q2, the factors contributing to the year over year decline include lower 4X6 print prices, lower ASP’s on small form factor books and building lease increase for our new Phoenix plant.

On the positive side, improvements of favorable product mix and continued leverage from shipping and materials cost nearly offset these negative variances.

Technology and development costs totaled $11.4 million for the quarter and include year over year increases of $550,000 for depreciation, amortization and stock based compensation. Excluding these amounts, our technology and development spending increased approximately $1.2 million or 19.5% from the prior year.

The majority of these increase in attributable to increases for power, co-location space and band width as well as increases in engineering head count.

Continuing down the income statement, sales and marketing costs totaled $9.4 million in the quarter, representing 23% of net revenues, down from the 28% expense level in the prior year. Excluding stock based compensation, sales and marketing costs represented 21% of net revenues down from 26% of net revenues in the prior year quarter.

Our Q3 customer acquisition costs also decreased from the prior year reflecting continued improved performance from our SEO optimization efforts and greater emphasis on promotional offers and product trials.

General and administrative expenses totaled $74 million in Q3 or 18% of net revenues compared to $6.9 million and 19% of net revenues in Q3 of last year. Excluding stock based compensation, Q3 general administrative expenses totaled $5.4 million representing a 6% decrease from the prior year.

On a year over year basis, total G&A expense reflects lower cost for salaries and benefits, professional fees and contractors, offset primarily by increases for corporate office space.

Continuing the discussion, adjusted EBITDA for Q3 totaled $2 million, far better than our guidance which ranged from a loss of $2 million to a loss of $3.5 million. This EBITDA improvement resulted from stronger than expected revenue growth combined with continued efforts across the company to efficiently manage our cost structure.

The quarterly effective tax rate was 30% reflecting the improved profitability in Q3 together with increased full year profit expectations. Please keep in mind that our current cash tax rate continues to be very low due to the availability of benefits and that our GAAP tax rate in very sensitive in either pre tax income or permanent tax differences.

On a GAAP basis for the quarter totaled $6.3 million or a net loss of $0.25 per share. On a non-GAAP basis, the net loss totaled $2.9 million or $0.11 per share. Shares used to compute the quarterly net loss totaled 25.5 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 $4.9 million which included $2.7 million for technology equipment and software, approximately $1.1 million for manufacturing equipment and building improvements and $1.1 million in capitalized software development costs.

Cash and liquid investments at September 30, totaled $63.3 million and reflects the typical seasonal low point in our annual cash flow cycle. In addition we continue to carry investment in auction rate securities totaling $42 million together with a $6.4 million asset representing the estimated fair value of our settlement right with UBS which is exercisable beginning June 30, 2010.

At September 30, approximately 75% of our auction rate securities were triple A rated and 25% were double A rated. And finally, we continue to receive all the interest payments on auction rate securities on schedule.

I’d now like to summarize our guidance for Q4 and updated guidance 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 our strategy and are pleased with our year to date financial results, we believe that the recessionary pressures on consumers have not fundamentally improved. 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 to reduce discretionary spending. Given these challenging circumstances, we will 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 weaker, non seasonal order volume with modest year over year increases during the traditional Q4 shopping period. We expect a consistent mix of revenues between new and existing customers with modest year over year growth in average order values. And finally we expect a continued shift of revenues from 4X6 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 on our strategy and are actively developing an increasing number of new customers. As I have mentioned in the past, commercial printing is still an early stage initiative and we do not yet have sufficient order volumes to provide a reliable revenue forecast. Accordingly, we are not providing any Q4 commercial guidance at this time. We will however, continue to report our progress on our next earnings call.

In terms of our cost structure, with net revenue products and a strong holiday marketing and promotion plan, we will begin the Q4 seasonal increase by sales and marketing spend which will extend well into the peak holiday season. These planned cost increases are reflected in today’s financial guidance.

And finally, while we remain firmly committed to our plan to increasing profitability and free cash flows, 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 updated guidance for 2009, starting with the full year. We now estimate that net revenues will total between $218 million and $228 million, reflecting a year over year increase ranging from approximately 2% to approximately 7%. Please note that these amounts exclude any Q4 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 margins to range from 52% to 54% of net revenues. The year over year decline is attributed primarily to margin loss from 4X6 print pricing and 2009 costs for severance and transition to our new Phoenix manufacturing plant.

We expect that our full year 2009 EBITDA margin will range from 16% to 18% of net revenues. In addition, we now expect the 2009 capital expenditures which includes capitalized product development costs will range from $19 million to $21 million. For your reference, capitalized product development costs totaled $3 million during the first nine months of 2009 and totaled $4.5 million in 2008.

Using the mid point to this updated guidance, we expect 2009 capital expenditures to range from 8.7% to 9.2 % of net revenues, a solid improvement from the 10.7% level reported in 2008 and a significant improvement from the 18.7% level reported in 2007.

Based on this guidance we now expect that our full year 2009 free cash flow will range from approximately $14 million to approximately $22 million, a clear confirmation that our strategy of selectively outsourcing peak manufacturing demand and closely managing our technology capital spending is beginning to pay off.

Turning now to Q4, we expect net revenues to range from $102 million to $113 million which reflects a year over year decline of approximately 4.4% to a year over year increase of approximately 5%. We expect our GAAP gross margin to range from 55% to 59% of net revenues and our non-GAAP gross margin to range from 56% to 60%. And finally, we expect our Q4 EBITDA will range from $33 million to $39 million.

So in summary, while our business continues to be challenged by the current economic environment, we are proud of our accomplishments so far this year and are well prepared for this year’s holiday season. 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.

Kristine Koerber – JMP Securities

Can you talk about the trends during the quarter especially with no major holidays falling in the quarter? Revenues came in better than expected. Can you comment on that?

Jeffrey Housenbold

The strength in the quarter came primarily from our Photo Books and our cards and stationary line, but Photo Books was the fastest growth rate in Q3 out of the year so far and we were using a mix of promotional and marketing initiatives to drive those sales. Part of that was partnerships as we mentioned in the script and some of that was an uptake in our new launch of the Simple Path creation and some of that was the traditional custom packs with just we’re seeing year over year growth rates accelerating in the quarter.

Kristine Koerber – JMP Securities

My next question was going to be on the Simple Path. Can you quantify the customer response? Are you seeing an increase? I’m just trying to figure out what’s going on with the average order size at check out now.

Jeffrey Housenbold

Two key things we’re looking at. One was the total sales of Photo Books and fortunately it looks like Simple Path is being incremental to overall Photo Books sales, so we look at the impact on custom pack and those growth rates who are healthy and continue to remain at that growth rate when we launched Simple Path.

As it relates to AOB, we’ve been defaulting the Simple Path price point to the soft cover 7X9 to lower the barriers to entry to really try to capture those 4X6 print customers, trying to present them with a product that is much better than prints but at roughly the same price point. So we’ll see a little drag on the AOB of Photo Books as a category as we continue to acquire people onto the franchise.

But we believe getting them into the franchise, showing them the wow factor of the Photo Books will lead to ever increasing life time values.

Kristine Koerber – JMP Securities

The commercial print business, the new clients that you gained during the quarter, was that from internal or external effort?

Jeffrey Housenbold

It was a combination of both. We have four sales people up and running who are out there building a pipeline and also our partnerships with both Group O and Inner Workings are starting to pay off.

Operator

Your next question comes from Imran Khan – J. P. Morgan.

Imran Khan – J. P. Morgan

I wanted to a little bit better understand your guidance. If I think about the mid point of fourth quarter guidance it’s more or less flat year over year revenue growth, and so what we wanted to understand is, that comes on the heels of about 13% growth in the third quarter. Is it just a conservative outlook for the holiday season? Is there anything that you’ve seen through October, any commentary about what trends have looked like through the first month of the quarter. And then can you talk about how trends looked inside the third quarter July versus August versus September.

Mark Rubash

I’ll start with the last point in terms of linearity in Q3. Clearly this year, August was the stronger month within the quarter. I think that had a lot to do with the promotional efforts we had underway particularly with the introduction of Simple Path. July was the slowest and probably due to peak holiday vacation season. July folks coming home with their pictures and back to school.

Last year we saw a little more strength in September with Photo Books, but this quarter was clearly July and I think clearly driven by products and promotions that we had going.

In terms of guidance for Q4 and the full year, I think a couple of points to consider; one is this guidance does not include any commercial. So if you just look at the core, it doesn’t change your point, but just to make sure that our commercial revenue in Q4 will be incremental to our guidance.

I think from a being cautious standpoint, this is a difficult challenge given where the economy is right now and particularly the consumer economy. I have probably watched all the different metrics as close as anybody has and frankly I really don’t believe that the fundamentals are better this year in Q4 than they were last year.

I think consumers just have fewer dollars that are available and the dollars that they are spending are going largely to staples as opposed to discretionary. That scenario combined with the fact that more than half of our revenue comes in Q4 and a significant portion of that comes in a three week period, just kind of magnifies the potential for an estimation error in terms of where our guidance is going to be.

If you look year to date and first nine months of 2009, the core consumer revenue has grown at about just a little under 7% for the first nine months, and the first nine months represents about half our year. So I think it is a bit on the conservative side, but I think this year there still remains a lot of potential for volatility depending on how the consumer pocket book and sentiment shapes up as we get closer to Thanksgiving.

As far as quarter to date, we’ve seen pretty steady trends in October through today in terms of visits and our conversions. I would say we’re on stand internally and I think optimistic, but again we’ll probably see north of 30% to maybe a little under 40% of our revenue will come in the three week period right after Thanksgiving.

Operator

Your next question comes from [Navid Kahn] for Youssef Squali – Jefferies & Company.

[Navid Kahn] for Youssef Squali – Jefferies & Company

On the guidance, if I look at the margin guidance and if I compare with last year, I think last year you were very close to 61% and this time you’re guiding to 60% on the high end on non-GAAP. Does this reflect some sort of promotion this year versus last year or is it there some mix issue?

Mark Rubash

I think biggest component of that, certainly we expect a little bit less contribution even though the comp on 4X6 pricing will be consistent. There will be a little bit of mix differential on prints. In terms of other cost components we are starting to see benefits from the lower labor cost from the Phoenix plant.

In Q3 when it was really in kind of partial ramp up mode with not a full complement of people, we had close to $250,000 of benefit in gross margin from the lower labor cost. So with a full quarter and a larger Photo Book mix I think that will start contributing.

And then lastly one of the differentials between Hayward and Phoenix is the building lease cost in Hayward was quite a bit lower than the lease cost of the building in Phoenix, so on a long term basis, this will work to our advantage because of the labor and power costs. But in the guidance it reflects that incremental cost versus Hayward.

[Navid Kahn] for Youssef Squali – Jefferies & Company

The other question I had was on commercial print. Can you talk about the pipeline that you have so far and what does it look like?

Mark Rubash

I would say it continues to grow. There are a lot of companies in the pipeline. I would say we’re starting to see our brand and our production capability and our price point starting. The word is getting out and it’s getting easier and easier to have discussions and requests for quotes. We’re continuing to get additional support from the Group O relationship as well as building on a relatively new relationship in process with Inner Workings.

So I think the thesis remains intact. I think the team is actually performing quite well and we saw a nice improvement in Q3.

Jeffrey Housenbold

The pipeline is building the offset to that is decision making is taking a little longer as companies are hedging their bets on their own internal marketing spend. So we think as Mark indicated the relationship build here will be a positive as we look towards growing the commercial over 2010 and 2011.

[Navid Kahn] for Youssef Squali – Jefferies & Company

So if I just understand, starting from Thanksgiving on, where you may not be able to reserve a pitch. You can pitch; you probably won’t be able to service because you have a ton of orders coming in, right?

Jeffrey Housenbold

That’s correct. There’s three or four weeks where we focus on the consumer business though few companies are sending out their marketing collateral material during that period. They send it ahead of time to drive Q4 revenue or they’re going to send it early Q1 to drive Q1 revenue. So kind of matches up with the demand curve in the industry, but we’ll be heads down on the consumer business during that time period.

Operator

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

Mitchell Bartlett – Craig-Hallum Capital

I wanted to follow up on the PP&S; you said it was the best unit growth, strongest this year in unit growth and PP&S was up on a revenue basis of 22%. Does that mean your average order values were down year over year and that you did better than the 22% in order revenue?

Mark Rubash

I’m not sure I followed the logic. We have seen the unit growth in Photo Books was the highest unit growth rate we’ve seen all year and that was largely driven by both promotion and the Simple Path launch.

What goes with that, because of Jeff’s point of the fault form factor on Simple Path right now is a lower priced Photo Books and it’s targeted at those customers who typically are more print focused and haven’t tried a Photo Book yet. So getting them into the category has been and will continue to be a big part of the marketing and promotion mix.

Mitchell Bartlett – Craig-Hallum Capital

A year ago at this time, most everybody was reeling with the recessionary pressures. October was horrible. You’ve seen steady momentum from what you had in September and October at least the way I interpreted the way you had to say, but year over year comparisons have got to be pretty strong at this point or did I misread that?

Jeffrey Housenbold

You have all the data everyone else does. The year to date growth on the core business has been about 7%. It has been building throughout the year about 3% in Q1, 8% in Q2 and about 9% in Q3. The question now and really with more than half our revenue at stake is how significant is the consumer spending going to be in Q4.

Mark Rubash

And keep in mind that unemployment this October is now double what the unemployment rate was October of ’08 so while I think the panic in the consumer’s mind has subsided to just thinking things are going to be tough for a long slog versus the world’s coming to an end, the actual unemployment and under employment rates are significantly higher and availability to credit as remarked by Visa yesterday and the shift to debit cards is I think indicative of consumers cutting back throughout the year.

Mitchell Bartlett – Craig-Hallum Capital

Could you help us understand, maybe you did this and I’ve been following through a couple of different calls here, but how new customers, the growth year over year in new customers, how that is on a percentage basis, and maybe attach that to that connection to share sites.

Jeffrey Housenbold

We don’t break out specifically new customers but overall transacting customers in the quarter grew 7%. Orders were up 3%. Average order value grew 6% year over year. So the transacting customer has had healthy high single digit growth rates.

In terms of new share sites, the primary metric that we look at internally is how many new registrants uploads and then ultimately how many customers are coming through those share sites, and we think the focus on groups where it just takes one member of that share site inviting 320, 30 100 other people gives us an opportunity to have leverage in exposure.

So if the group is making a Photo Book for the soccer coach and that’s 20 parents, we have access and the ability to get share out of those 20 parents even if some of those tend to do 4X6 prints at Wal Mart or Kodak customers or Snap Fish, they’re getting exposed to our quality, to our form factors, to our customer service.

So we think as we continue to grow share sites, as we continue to enhance the feature functionality on the share sites as it relates to product creation, that we’ll continue to see increasing numbers of new customers and transactions from those share sites.

Mitchell Bartlett – Craig-Hallum Capital

In Q3 did you see prior period registrants become customers and a good connection with that effort?

Jeffrey Housenbold

Yes, we’re seeing people who are kind of going through that evolution of becoming exposed to registrants uploads to first purchase to multiple purchases. So we’re seeing the traditional life cycle work on the share site recipients as it would other customers.

And the key to Simple Path which is integrated into the share sites, if the parents of the kids soccer team are uploading pictures to that share site, right there instantly through our new Simple Path, the Photo Book is already made for them so they can simply one check out or with a couple clicks and edits, customize the book more towards their kid and be able to print that.

So we’re excited about what Simple Path could do in the short term, but I think the real opportunity here is, think about the 450 million 4X6 print transactions that occur in America every year, versus the eight to nine million Photo Book transactions that are occurring.

If we can convert some of that 450 million print transactions into Photo Book transactions, you could see the size the franchise could grow considerably.

Operator

Your next question comes from Shawn Milne – Janney, Montgomery Scott.

Shawn Milne – Janney, Montgomery Scott

I want to go back to that last question on the transacting customer growth. The share site numbers are all up and the usage metrics look healthy, but sequentially the order and transacting customer growth went down and the transacting customer went down a fair amount. Is there something in the year over year comp in Q3 of last year that’s making that look a little funny because it did slide about 600 basis points? And CapEx is going to be lower. Is this something that you’re deferring spending until next year or is this a continuation of your efforts to keep CapEx well controlled. And then sales and marketing, well under our expectations; is this upside from commercial revenue with a little less variable cost on sales and marketing, is that the impact or is there something else there.

Jeffrey Housenbold

Keep in mind in the latter part of Q3 last year; we cut the price of 4X6 prints from $0.19 to $0.15 so you had partial unfavorable comps Q3 over Q3. The other thing to keep in mind sequential is that Q3 typically is a low for us given that there’s no major holidays and a lot of people are out travelling where they’re generating memories and images that end up uploaded and ultimately given as gifts and memories throughout the fourth quarter. I think those are the two key things to keep in mind.

Mark Rubash

With respect to CapEx, really the things that we have been doing, one on the technology side, very clear we’ve been focusing very hard on getting competitive, competition into our hardware stack. We have multiple storage vendors in the stack today and with the opportunity to go to even lower cost types of storage devices, the price for storage has been coming down significantly over the past year and we expect that trend is going to continue.

So one on the technology side just being very focused on adding the right storage vendor at the right price when we need it and scrutinizing all other types of spend. We’re not deferring anything certainly on support of the site.

On the manufacturing side, I think two things are at play. One is obviously the slower growth rate comes into play. The second is that we have probably the most modern fleet or up to date fleet of digital presses that we’ve ever had so the throughput on those machines is better than what it’s been and the price has been pretty consistent with older model machines.

And then probably most importantly is we’re not adding incremental capacity for the highest geeks in Q4, so the number of outsource partners that we use for the what’s differentiated product in Q4 has increased quite a bit while still maintaining quality.

So if you can bring the cost of technology CapEx which historically has been about half of our total CapEx, that’s come down significantly and then limit the growth in manufacturing capacity. You see it came down very quickly to below 10% level and I really do feel that is sustainable for the foreseeable future. I feel very confident about that.

And with respect to sales and marketing, one of the things we did this quarter was to rely a little more heavily on promotional offers versus hard dollar working marketing dollars in Q3. Without a holiday rich period, it’s just a shift in strategy to put more of the online and offline dollars into the Q4 time period and rely more on promotions in Q3.

So as a percent, total marketing as a percent of our customer acquisition as a percent, it actually came down a little bit. Our online spend CPA went up slightly from the last couple of quarters, a little less efficient but in trend or on trend with where we’ve been the last few quarters.

Shawn Milne – Janney, Montgomery Scott

So to just wrap up on that, basically it would be impacting gross margin more than flowing through sales and marketing, right?

Mark Rubash

Right.

Shawn Milne – Janney, Montgomery Scott

Was my comment correct with the $1.2 million in commercial revenue would come with a relatively fixed marketing cost tied to it, just a sales person?

Mark Rubash

Yes, there’s virtually no sales and marketing cost for the commercial team other than the direct sales team, the four people which are low base and commission structure.

Operator

Your next question comes from [Kevin Koppleman – Cowan & Company]

[Kevin Koppleman – Cowan & Company]

Could you give us a little more color on the competitive environment and have you seen any impact from Vista Print selling photo books or from Kodak galleries price 4X6’s?

Jeffrey Housenbold

We’re coming up on our tenth anniversary of the company where we pioneered the online sharing photo space, and since we launched we’ve always faced competitors; some new entrants and VC back companies, but historically they’ve been large companies like Wal Mart, like Target and Kodak and Hewlett Packard, Yahoo and Microsoft and AOL and Google and Adobe, and yet while there’s been a lot of competition, I think our singular focus in this category, our relentless pursuit of innovation and our high customer loyalty rates have led us to become the market leader and the most profitable in this space as well.

So I think those trends will continue as we continue to innovate and listen to our customers and meet their needs of what they need in the memory sharing and social expression space.

In terms of Vista Print’s entrance in the space, first of all they’ve been in this space for two or three years. They used to call it Holiday. Now they’re calling it Consumer. But their company is more geared toward a lower service, lower price, lower quality offering more consistent with where Snap Fish and Wal Mart are position in the marketplace.

So we’re not seeing impact from their continued focus in this area. I think it’s going to be felt by the Snap Fish’s and Wal Mart’s more than us.

In terms of Kodak, Kodak has had numerous strategies throughout this year as they’ve fallen to a distant third in this space where five years ago they were a very strong number one and so there’s been $0.09 prints available in the marketplace for quite a long time.

So the customers we have who want the $0.09 prints have had ample opportunity to go other places. Keep in mind the average price of a 4X6 according to PMA in the industry is $0.13 to $0.14 and our list price is $0.15 and we offer prices as low as $0.10 through our prepay print plans, so our blended cost of a print is about the average of the industry, and we grew units this quarter as we’ve done every quarter this year, total revenue from 4X6 prints has been down slightly but we’re seeing positive unit growth.

So we’re not seeing impact from Kodak’s moves nor are we seeing impact on our business from Vista Print.

[Kevin Koppleman – Cowan & Company]

On the Photo Books it sounds like Simple Path, you’re almost using that as a tool to help transition your prints customers into Photo Books. Is that the right way to think about it?

Jeffrey Housenbold

Absolutely. Our goal over the next few years is to essentially put the 4X6 print out of business and we mean that in a positive way in that it’s an old form factor from an old technology that happens to be the customer’s habit and understanding, and we want to expose them to a much richer disk and the higher value equation that a Photo Book provides.

If we can eliminate the creativity gap and the time gap through automating that process and making it for them, we think there’s a lot of elasticity and growth ahead for the Photo Book market. At 450 million print transactions, average print transaction is 50 or so prints, that makes a wonderful simple path book at a higher revenue and higher margins for us going in the future.

Operator

Your next question comes from Michael Olson – Piper Jaffray.

Michael Olson – Piper Jaffray

I’m wondering if you’d be willing to hazard a guess on what percentage products will be as a percent of revenue for 2010.

Jeffrey Housenbold

We would be happy to on our January call. I think the key thing to keep in mind is look at the trend for the last three or four years. That trend will continue. We don’t think prints goes to zero obviously in 2010 but over the next few years prints in the category should be in the 20% range so we think as we continue to innovate and cards and stationary and Photo Books and our strategic stated comparatives it will continue to increase.

Last year 4X6 prints as a total revenue approximated 18.3% and we believe with the price cut and the increase in growth in the PP&S that number should come down again as well.

Michael Olson – Piper Jaffray

On the motion box video sharing partnership are there any indications you can give us there regarding how that’s going, any metrics as far as usage or anything like that you could share?

Jeffrey Housenbold

Nothing specific. I would say that adoption continues to grow week over week, month over month. The enhancements we made to the user experience this quarter was largely a partnership that was outside the major shuttle slide flow. We brought that into the customer’s flow by putting it into a light box and allowing them to have greater visibility, greater control and flexibility to post those videos to different places on the web.

So we think that will continue to grow but that is very, very early days. We’re running it essentially, the storage costs are premium. It offsets the people who don’t upgrade to the premium. So we don’t foresee it being a large revenue driver here over the next 12 months or so, but I think it important to differentiate in the market place for us, important to test and learn Sandbox to learn how customers interact with video relative to photos and important test on Sandbox for us to understand their propensity to pay for subscription based services.

Operator

There are no more questions at this time. I’d like to turn the conference back over to Jeff Housenbold.

Jeffrey Housenbold

Thanks everyone for joining us on today’s call. I think as indicated by my and Mark’s comments, we made a tremendous amount of innovations in the third quarter that I think key us up very well for the fourth quarter in terms of designs, ease of use and differentiation in the marketplace. I think we are being appropriately cautious going into the fourth quarter given the macro economic environment, but I am very confident in the team’s ability to execute particularly on the manufacturing side with Phoenix fully ramped up and operational along with Charlotte this year, and as Mark indicated, state of the art machines with higher throughput.

We’re looking to continue to delight our customers, expand our revenue, increase EBITDA and as we’ve been doing throughout last year and the first three quarters this year, increasing the free cash flow available to shareholders so we look forward to updating you in January after our seasonally strong fourth quarter.

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