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Bill Simpson published an analysis for Tradingipos subscribers of Shutterfly's (NASDAQ:SFLY) IPO on September 23rd. The company priced at $15 a share, the high end of its range. The text of the original write up follows:

Shutterfly plans on offering 6.7 million shares (assuming over-allotment) at a range of $13- $15. Insiders are selling 0.9 million shares of the offering. JP Morgan is lead managing the offering, Piper Jaffray and Jefferies co-managing. Post-offering SFLY will have 23.6 million shares outstanding for a market cap of $330 million in a $14 pricing. IPO proceeds will be used for general corporate purposes.

3 venture capital entities will own approximately 55% of SFLY post-offering.

From the prospectus:

We are an Internet-based social expression and personal publishing service that enables consumers to share, print and preserve their memories by leveraging our technology, manufacturing, web-design and merchandising capabilities.

Might not be able to tell from that sentence, but SFLY allows users to upload, edit, enhance, organize, find, share, create, print and preserve their digital photos. Print revenues are derived from sales of photo processing of digital images, including sales of 4x6 prints, and the related shipping revenues from these sales. Other then prints, SFLY also offers photo-based merchandise, including calendars, greeting cards, scrapbooks, mugs, mouse pads, bags, puzzles, playing cards and apparel. 4X6 photo prints, however, account for the majority of revenues.

In addition to online printing and ordering, SFLY also enable customers to develop on-line photo albums to share with others.

SFLY derives approximately half of their entire annual revenues in the 4th quarter of each year. Based on surveys, SFLY believes their customer base consists of approximately 84% female, approximately 63% in the 25-44 age range and approximately 53% with children. 98% of all customers are in the US. Since inception in 1999, SFLY has fulfilled more than 12 million orders, sold approximately 370 million prints and stored approximately one billion photos in the image archives.

SFLY has a major problem: Digital photo printing has essentially been commoditized. Competition is everywhere from online portals such as Yahoo (NASDAQ:YHOO) to large big box retailers such as Wal-Mart (NYSE:WMT). Literally everyone will print your digital photos and online photo communities are pervasive. SFLY was an early mover in this space, but they've absolutely no price leverage nor anything approaching a barrier to entry. The numbers point this out, as gross margins are deteriorating and operating expense ratios are growing. This is the opposite of what one wants to see in an IPO.

A prime example of what is occurring to SFLY: in the 2nd quarter of 2005 a number of SFLY's competitors dropped their prices for printing 4X6 digital photos from $0.29 to $0.12. That is a huge drop and to attempt to continue competing SFLY dropped their 4X6 prices to $0.19. Big box retailers and online portals both have a myriad of other revenue sources and can use digital photo printing as a loss leader to drive traffic. They can essentially give them away to increase customer flow, while digital photo printing is the only game in town for SFLY. Yahoo is currently $0.15 or less for 4X6 prints undercutting Shutterfly's $0.19. Why would anyone pay more for Shutterfly? It is a good question. Yahoo is the #1 site on the web and Shutterfly is #1,100. How can SFLY compete by charging more per pricing then Yahoo?

The March and June 2006 quarters were SFLY's lowest gross margin quarters in their operating history. Through the first 6 months of 2006, gross margins declined 2% from the first 6 months of 2005 while R&D, sales & marketing and general & administrative expense ratios were ALL up over the corresponding 6 months of 2005. SFLY's margins and expense ratios are all trending the wrong way, a direct result of digital printing prices failing swiftly. This is enough to pass on this offering right here. I'll summarize the financials and forecast, but you want to avoid an IPO whose metrics are all trending the wrong way.

Financials

  • $4 per share in cash post-offering, no debt.
  • Revenues grew 54% in 2005 to $84 million. SFLY's revenues this decade have benefited from the growth of the digital photo market. Gross margins were 56%, operating expense ratio was 50%. Net margins after tax were 3.5%. This was not a high margin model to begin with, let alone when digital print costs begin falling rapidly. Earnings per share in 2005 were $0.13. On a $14 pricing, SFLY would be trading 108 X's trailing earnings.
  • Because SFLY derives approximately 50% of revenues in the 4th quarter, revenues through the first 6 months of 2006 are not comparable to full year 2005. Instead we need to just compare to first 6 months of '05 and it isn't real pretty. Revenues do appear as if they will rise in 2006 overall by 25%-30% to $105- 110 million. That is the good news. Gross margins slipped to 49% first 6 months of '06 compared to 51% first 6 months of '05. The larger concern is that operating expenses have increased to 66% of revenues from 57%. Not good, that is a huge increase, especially when factoring in the 30% revenue increase. In fact the deteriorating gross margins and the big increase in operating expense ratio will make it very difficult for SFLY to be net positive in 2006. Through the first 6 months SFLY lost $0.25 a share compared to a $0.06 loss the first 6 months of 2005. I think SFLY will lose money in 2006, at best break even.
  • Spurred by strong pricing in a newer market digital photo printing, SFLY has made a profit each of the past 3 years. Pricing in the digital photo printing space have dropped significantly and there is the very real possibility SFLY may never earn a bottom line profit again. SFLY margins are all trending the wrong way as SFLY just does not have any pricing power in a competitive sector. What SFLY does have currently are unique visitors and users and the internet sector is one flush with cash. SFLY then does have value; however I'm passing here easily in range. SFLY is going from profitability to operational losses; I don't have any interest here. I've liked a number of the internet deals this year. I don't care for SFLY.

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