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Executives

Michael Look - Vice President of Investor Relations

Jeffrey T. Housenbold - Chief Executive Officer, President and Director

Brian M. Regan - Chief Financial Officer and Senior Vice President

Analysts

Naved Khan - Cantor Fitzgerald & Co., Research Division

Paul Judd Bieber - BofA Merrill Lynch, Research Division

Andrew Marok - Cowen and Company, LLC, Research Division

Shawn C. Milne - Janney Montgomery Scott LLC, Research Division

Stephen Shin - Morgan Stanley, Research Division

Aaron M. Kessler - Raymond James & Associates, Inc., Research Division

Victor B. Anthony - Topeka Capital Markets Inc., Research Division

Colin A. Sebastian - Robert W. Baird & Co. Incorporated, Research Division

Christopher Merwin - Barclays Capital, Research Division

Heath P. Terry - Goldman Sachs Group Inc., Research Division

Trisha Dill - Wells Fargo Securities, LLC, Research Division

Brian Patrick Fitzgerald - Jefferies LLC, Research Division

Kerry K. Rice - Needham & Company, LLC, Research Division

Shutterfly (SFLY) Q3 2013 Earnings Call October 29, 2013 5:00 PM ET

Operator

Welcome, everyone, to Shutterfly, Inc.'s Third Quarter 2013 Financial Results Conference Call. This call is being recorded. I would now like to turn the call over to Michael Look, Vice President of Investor Relations for Shutterfly. Please go ahead.

Michael Look

Thank you, operator. Good afternoon, everyone. Welcome to Shutterfly's Third Quarter Fiscal 2013 Conference Call. With us today are Jeff Housenbold, Chief Executive Officer of Shutterfly; and Brian Regan, Chief Financial Officer. By now, you should have received a copy of our earnings press release, which crossed the wire approximately 1 hour ago. If you need a copy of the press release, you can go to shutterfly.com under the Investor Relations link to find an electronic copy. We have also released a presentation that we will use as we go through this call. Call participants are advised that the audio of this conference call is being recorded for playback purposes and that a recording of this call will be made available on our website within a few hours. You can access these recordings through the Investor Relations section of our website at shutterfly.com.

Before we begin, I'd like to note that our discussion today will include forward-looking statements within the meaning of the Securities Act of 1933 and the Securities Exchange Act of 1934. These forward-looking statements include statements about our business outlook and strategy and the assumptions underlying those statements, and statements about historical results that may suggest trends for our business. For more information regarding the 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 related to our business in general, we refer you to the Risk Factors section of the company's most recent Form 10-K and Form 10-Q, and its other filings with the SEC. I would also like to note that any forward-looking statements made on this call reflect information and analysis of -- as of today, and the company assumes no obligation to update this information.

This presentation contains certain financial performance measures that are different from financial measures calculated in accordance with GAAP, and may be different from calculations or measures made by other companies. A quantitative reconciliation of these non-GAAP financial measures to the most directly comparable GAAP financial measures is available in our third quarter fiscal 2013 financial results 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. Jeff?

Jeffrey T. Housenbold

Thanks, Mike. Good afternoon, everyone, and welcome to our third quarter 2013 earnings call. I will start today's discussion with the summary of our Q3 headline results followed by an update on our operational and strategic initiatives as we head into this year's holiday season. I will then turn the call over to Brian, who will review our third quarter financials in detail and provide updated guidance for Q4 and full year 2013. We will then open the call up for your questions.

As you can see from our earnings press release issued earlier today, Shutterfly posted another quarter of strong revenue growth and improved profitability across all of our consumer brands and our Enterprise business.

During Q3, net revenues grew year-over-year for the 51st consecutive quarter to $122.7 million. This 25% increase from the same quarter a year ago was achieved during our slowest seasonal quarter and comping against last year's acquisition of Kodak Gallery's customers. Adjusted EBITDA for the third quarter was a loss of $1.1 million and reflects operational efficiency gains for manufacturing and marketing, resulting from our increased scale and the shift of certain marketing expenditures into the fourth quarter.

Along with our strong financial performance in Q3, we continue to make significant progress on the key elements of our growth strategy.

During the third quarter, we introduced several new innovative offerings in time for this year's holiday season. At our flagship brand, Shutterfly, we added more color, layout and back of card options to our holiday card lineup, introduced 5x7 Tri-Fold greeting cards and expanded our assortment of premium card features to include rounded corners and pearlescent paper. To help families capture the perfect photo for their 2013 holiday card, Shutterfly is sponsoring holiday photo shoots during November at 15 Westfield Shopping Malls across the country. Consumers can drop in, have their photo taken for free and then log into one of our websites to create their own personalized holiday greeting card.

In Photo Books, we continue to expand our premium photo book collection adding 2 new form factors, soft and hardcover 10x10 photo books and hardcover 11x14 photo books. Within our popular Photo Gift category, we introduced several exciting new products, such as personalized iPad cases, curved glass prints, table runners, metal holiday ornaments, dry erase decals and framing options for our canvas prints. We also began to in-source the production of our smartphone cases, providing better margins from this popular gift. As a result, we now offer both a traditional online slim case and a silicon line tough case in either glossy or matte finish for both the iPhone and Samsung Galaxy.

At our premium Tiny Prints brand, we added 3 new trim options, expanded our premium envelope collection to include personalized envelope liners, upgraded the thickness of our signature matte and double-thick papers, and launched the line of holiday card and stationery designed by Rebecca Minkoff. We are also excited about the introduction of foil stamped cards coming next month and this season's most cutting-edge card offering called clear cards. Leveraging the unique properties of plastic, we have created exclusive designs that incorporate transparent areas to show off the uniqueness of a clear card.

In addition to these exciting new product introductions, we launched Super Rush Plus on Tiny Prints, an enhancement to the popular Super Rush program. Customers can now place their holiday card order by 1:00 p.m. Eastern Standard Time and receive their holiday cards the next business day. We believe this exciting new expedited option will be a key differentiator during this year's shortened holiday season.

Lastly, for the consumer who wants that truly one-of-a-kind holiday card, we are offering our platinum design service on Tiny Prints. For just $1,000, customers receive one-on-one time with a personal holiday card designer, who will create a completely custom holiday design that can be used for all of your stationery needs, including holiday cards and coordinating "thank you" notes, envelope liners, address labels and more.

Shifting now to our earlier stage growth initiatives. In August, we launched our professional printing service for Wedding Paper Divas customers. Utilizing this new service, couples can now easily brand their big day from beginning to end with their own designs to create beautiful, one-of-a-kind wedding stationery products such as save-the-date notices, wedding invitations, programs, menus and place cards, as well as engagement party, bridal shower and rehearsal dinner invitations. At our Treat brand, we added digital cards providing customers the option of sending their personalized greeting instantly for just $0.99.

Turning now to our Enhanced Cloud Service. Last week, we launched the beta version of our ThisLife service. We believe ThisLife will address the increasing need for customers to manage their ever-growing collection of photo and video memories, and will further increase the sell-through of our unique personalized products and gifts from these memories. Our ThisLife service enables consumers to gather and organize photos and videos from across devices, cloud services and social networks. Then utilizing easy-to-use features like facial recognition, duplicate detection, chronological organization and simple search, users can interact with their memories by person, place or event. We are excited about the next generation way in which consumers aggregate, interact and share their personal memories, and look forward to gathering customer feedback during our beta period. We will also roll out many new capabilities and features over the next few quarters that will continue to differentiate our service and delight our users.

We also continue to make great progress against our mobile initiative, making it easier and more convenient for consumers to transform their memories into high-quality photo products, regardless of device, platform or location. During Q3, we expanded the feature set of our iPhone and iPad apps, and in August, we launched our new photo book creation app for the iPad called Photo Story. Photo Story uses multimedia features to bring stories to life, including first-of-its-kind digital audio recordings that can be shared via a QR code included on the printed photo book. In addition, we've upgraded and [ph] our recently launched Android app, to include e-commerce capability. Our investments in mobile are paying off.

During the third quarter, we estimate that nearly 7% of our Shutterfly-branded revenue was derived from mobile sources, including our native apps in our M.dot in T.dot [ph] enabled sites, up from approximately 5% in Q2. We also continue to augment our organic growth by leveraging our strong balance sheet to make strategic, disciplined acquisitions as evidenced by our acquisition of R&R Images in August and BorrowLenses last week.

We now are operating a portfolio of 7 consumer-facing premium lifestyle brands, including Shutterfly, Tiny Prints, Wedding Paper Divas, ThisLife, Treat, MyPublisher and BorrowLenses, along with our growing Enterprise offering.

Let me take a moment to briefly discuss the rationale behind our 2 most recent acquisitions starting with R&R Images. R&R is a small marketing solutions and manufacturing company that specializes in short-run, high-touch digital print offerings. As an established outsourced printing partner of Shutterfly, R&R immediately adds certain new printing capabilities that benefit both consumers and Enterprise customers, and improves margins by eliminating the middleman. The size of this transaction was small and will have an insignificant impact on Q4 Enterprise revenues, but will provide additional substrates and products for our customers this quarter, such as our new Tiny Prints foil stamped holiday cards.

BorrowLenses is the premier online destination for photographic and video equipment rentals. As an early-stage growth opportunity, our acquisition of BorrowLenses will enable Shutterfly to engage deeper with prosumers and professional photographers, increase high-quality memories on our platforms, improve our ability to cross-sell new services, smooth seasonality, and diversify our revenue streams by tapping into the emerging sharing economy. This transaction is not expected to have a meaningful impact on our Q4 revenues and is reflected in today's guidance.

In closing, as we head into my 9th holiday season here at Shutterfly, I am enthusiastic about our prospects for this Q4 as this year's lineup of products, services and user experiences is by far our strongest. And the company is well prepared to handle the expected increased order volumes in a shortened holiday season.

With that, I will now turn the call over to Brian to review our financial results and outlook in greater detail. Brian?

Brian M. Regan

Thanks, Jeff, and good afternoon, everyone. I'll begin my comments today with some observations about our third quarter performance, key metrics and operating results. I'll then conclude with an overview of our Q4 financial guidance and an update to our full year outlook for 2013 before opening the call up for your questions.

Earlier today, we posted third quarter results that were better than the high end of our guidance ranges for net revenues, adjusted EBITDA, net loss and EPS. Taking a detailed look at our results, net revenues for the third quarter totaled $122.7 million, a 25% increase over the prior year and above the $117.5 million high end of our guidance range. Consumer revenue totaled $112.7 million, reflecting 25% year-over-year growth, driven by strength across all of our premium brands. Net revenue from our Enterprise business grew 22% over the prior year to $10 million, driven by continued organic growth at a number of existing clients, in addition to a very modest partial quarter contribution from R&R Images.

During Q3, average order value or AOV grew 16% year-over-year to $29.07, the highest level for a third quarter in the company's history. Q3 strong AOV results reflect the strength of our loyal customer base and continued benefit from a number of pricing and promotional initiatives.

During Q3, total unique transacting customers and orders increased year-over-year 6% and 8%, respectively, as we are now lapping the -- our migration of Kodak customers. Q3 unique customers totaled $2.4 million, generated -- generating nearly 3.9 million orders across all of our lifestyle brands.

Moving to cost of revenues and gross margins. GAAP gross margin in the third quarter was 41.9%, above the 41.5% high end of our guidance range. As expected, our year-over-year decline in gross margin of 217 basis points was largely driven by higher depreciation, equipment expenses and increased customer service costs related to our new Fort Mill, South Carolina facility, as well as lower ASPs in certain product SKUs. These increases in cost of goods sold were partially offset by lower materials costs related to our increased scale and in-sourcing, lower shipping rates, as well as a favorable shift in product mix.

Turning now to operating costs. Excluding stock-based compensation, OpEx totaled $72.7 million, reflecting the increased cost structure from acquisitions and purchase accounting amortization. Looking more specifically at our operating expense components, technology and development costs totaled $27.5 million for the quarter or 22% of net revenues. Excluding stock-based compensation and depreciation, our technology and development spending increased approximately $3.7 million or 22% from the prior year. Q3's increase in technology and development spending largely reflects the incremental costs associated with our recent acquisitions, as well as continuing investments in technology and development headcount.

Sales and marketing expenses totaled $36.8 million in the quarter or 30% of net revenues, consistent with Q3 of last year. Excluding stock-based compensation and amortization, sales and marketing expense increased 15% from the prior year period to $26.4 million or 21% of net revenues, down from 23% in Q3 of last year. This decrease in sales and marketing expense as a percentage of revenue was largely driven by improvements in our overall marketing efficiency, as well as a continued shift in the timing of some of our marketing campaigns from Q3 to coincide with our compressed Q4 holiday peak period.

General and administrative expense for the quarter totaled $21.7 million or 18% of net revenues, and excluding stock-based comp and credit card processing fees, G&A expenses represented 11% of quarterly net revenues, approximately in line with Q3 of last year. Adjusted EBITDA for the quarter was a loss of $1.1 million, better than our guidance of adjusted EBITDA loss of $6 million to $8 million. Our favorable Q3 EBITDA results reflect the combined effect of solid revenue growth and continued operational efficiencies, as well as the shift in the timing of certain marketing investments into Q4. The effective tax rate for the quarter was 73%, and was impacted by fixed rate items such as disqualifying dispositions of incentive stock options during the quarter, coupled with the impact of our revised guidance.

Net loss for the quarter on a GAAP basis totaled $10.1 million or a loss of $0.27 per share.

Normalizing for the impact of our convertible note offering on our EPS, non-GAAP net loss was $9 million or a loss of $0.24 per share. The weighted average shares used to calculate the net loss per share totaled 37.8 million shares.

And finally, capital expenditures during the quarter totaled $24.7 million, including $12 million for technology, equipment and software; $8.4 million for manufacturing equipment and building improvements; and $4.3 million in capitalized software development costs.

Cash and liquid investments at quarter end totaled $335 million. In addition, we have access to our yet untapped $125 million revolving credit facility.

To conclude our prepared remarks today, I'd like to summarize our outlook for the fourth quarter and the full fiscal year 2013 and share some insight into our underlying assumptions.

Through the first 9 months of 2013, we have strengthened our market-leading position through continued innovation and strong execution. However, as a consumer-facing business, we are also mindful of the current state of the U.S. economy and the impact various external factors may have on consumer discretionary spending this holiday season. We remain cautious of the persistently high underemployment rates, heightened uncertainty surrounding macroeconomic and competitive landscapes, highly volatile consumer sentiment following the recent government shutdown and the upcoming federal budget and deficit negotiations in Washington, D.C., and last but certainly not least, this year's shortened holiday shopping season. We have incorporated the potential dampening effect these factors could have on holiday spending and our resulting fourth quarter results.

In addition, we recently terminated part of our Costco relationship related to Tiny Prints holiday cards on the Costco website. This was a result of Costco recently asking us to lower the price point of our cards. Given the premium brand positioning of Tiny Prints and our market-leading quality, we decided this was not in Shutterfly Inc.'s best long-term interest to continue the ship-to-warehouse aspect of our Costco partnership. Since this decision came late in the season, we will not have time to make up this lost revenue through other partnerships and have reduced our Q4 revenue guidance by approximately $8 million to reflect this contract termination. With these comments as context, we expect net revenues in Q4 to range from $392.1 million to $405.1 million, which reflects year-over-year growth of up to 15.2%.

We expect our Q4 GAAP gross margin to range from 60.3% to 61.3% of net revenues, and our Q4 GAAP operating income to range from $94.9 million to $105 million. We estimate our adjusted EBITDA for Q4 will range between $129.2 million and $139.3 million and that our GAAP effective tax rate will range between 57.6% and 59.9%. We expect the GAAP net income per share to range from $0.92 to $1.08 per share based on approximately 39.9 million weighted average common shares.

Excluding the effects of our convertible note offering, we expect non-GAAP net income per share to range from $0.95 to $1.11 per share.

Turning to the full year. We now project our 2013 net revenues to total between $765 million and $778 million, which reflect year-over-year growth of up to 21.4%. And we are increasing our full year GAAP gross margin to range from 52.9% to 53.5% of net revenues. We currently forecast that our GAAP operating income will be approximately $12.4 million to $22.5 million. And we are reiterating our estimate that our full year 2013 adjusted EBITDA margin will be 18% to 19% of net revenues, or $137.7 million to $147.8 million.

The full year GAAP effective tax rate is now expected to range from 30% to 35%. We now expect full year GAAP net income per share to range from $0.06 to $0.22 per share, and excluding the effects of our convertible note offering, we expect full year non-GAAP net income per share to range from $0.20 to $0.35 per share, slightly widening our previous non-GAAP EPS guidance of $0.23 to $0.33 per share. And finally, we expect that 2013 capital expenditures will range from 9.8% to 10.4% of net revenues.

In summary, we believe that our Q4 and revised full year 2013 financial guidance gives appropriate weight to our most recent business performance and the current and anticipated market conditions. So with that, I'd like to thank you for your time today and open the call up for your questions.

Question-and-Answer Session

Operator

[Operator Instructions] The first question comes from Youssef Squali from Cantor Fitzgerald.

Naved Khan - Cantor Fitzgerald & Co., Research Division

This is actually Naved Khan for Youssef. Just a couple of questions. On the guidance, thanks for sort of parsing out the different elements of what went into the guidance, but just to go a little bit further into it, if you sort of look at your historical tracker curve [ph] and in the past, if you have seen any impact from the shortened holiday season, how much have you seen in your financial history so far? And then if -- I mean, I understand that there is a lot of uncertainty in the macro front and with the budget price and all that, but can you talk about what you saw in October in terms of consumer behavior, and whether you noticed any changes? And then I had a follow-up.

Jeffrey T. Housenbold

Sure, Naved. This is Jeff Housenbold. So let me try to just to reiterate what -- from Brian's prepared remarks on guidance. We over-delivered in Q3 by about $5 million and we took a long-term point of view on one aspect of our Costco relationship. Instead of lowering the price point, we decided to exit that part of the business, and Costco remains an important partner of ours, but we thought that was in the long-term interest of the company, and that was a loss of about $8 million. So when you net that out, that's a negative $3 million. We took the high end of our range down from 7.81 to 7.78 to reflect that. We also -- we saw it again today. We saw it last week. You're seeing consumer sentiment numbers be low, greater uncertainty, many other companies talking about sequestration and the government furlough, and so we took that into account, particularly given that our historical Q4 revenue range in terms of guidance has been 2.5% to 3% of annual net revenues. As we were going into this fourth quarter, it was less than 1%. So we also expanded the guidance range to about 1.7%, which is about half of what it's historically been. So those were the causes of the lower guidance. We don't comment about inter-quarter results, but also keep in mind, as of today, we've only seen about 5.1% of the full quarter's revenue. So the first month here is fairly insignificant as it relates to the overall quarter. But we had a very good third quarter, as demonstrated by the results we've put up across our now 7 consumer brands, and we think we have the best lineup of products and services, the best prepared team we've ever had going into this important fourth quarter.

Naved Khan - Cantor Fitzgerald & Co., Research Division

Okay. Great. And then just in terms of the promotional environment and the promotional intensity, what are you baking in and what are you seeing so far?

Jeffrey T. Housenbold

Yes, I think we're baking in roughly the same promotional environment that we've seen over the last 4 quarters, so taking Q4 of '12 and the first 3 quarters of '13 into account and keep in mind, according to InfoTrends, we have about 61% of the market today, the next nearest competitor is Snapfish, at about 7 or 8. And I think users put out an interesting note looking at Google queries and comp score data suggesting they're down significantly in traffic, so we think where pulling ahead of the competition, dampening the effect of any potential promotional activity from the competitors as well.

Naved Khan - Cantor Fitzgerald & Co., Research Division

Okay. Great. Lastly, on the -- just on the BorrowLenses, the acquisition. I mean, I understand the part that's in order to expand the breadth of the offering, but sort of in terms of just the cross-sell opportunity and sort of the bigger picture in terms of volume -- what the potential might be? Can you just talk about it a little bit more?

Jeffrey T. Housenbold

Sure. Keep in mind, our mission has been to help consumers capture, share and preserve their most precious moments with people that matter most in their lives, and BorrowLenses helps both the prosumers and professionals take better pictures. So we believe that there's higher-quality pictures that are centered around people's key life moments and those get onto the Shutterfly ecosystem, that benefits our shareholders. BorrowLenses is the leader in their space in this rental economy, not dissimilar from like Airbnb or HomeAway or RelayRides or Uber, in kind of the sharing economy, and we're going to be able to offer their products and services to the tens of millions of Shutterfly users, helping to generate increased revenue on the BorrowLenses brand and the ability to sell-through to prosumers and professionals, both our Shutterfly, Tiny Prints and now MyPublisher products, as well as Wedding Paper Divas. So we think there's natural synergies amongst the missions. The fact that we're both premium lifestyle brands, the fact that we're both market leaders and a shared vision of where the world's going from a technology and a memory-capture standpoint. So we're excited about welcoming Max and Mark and the entire BorrowLenses family to Shutterfly.

Operator

The next question comes from Paul Bieber from Bank of America Merrill Lynch.

Paul Judd Bieber - BofA Merrill Lynch, Research Division

I was hoping you could provide a little bit of additional color on the increase in AOV given the backdrop of decelerating orders and customers? Does the deceleration -- is the last thing Kodak responsible for, the majority of the deceleration in orders and customers? And then secondly, I was hoping you'd comment on organic growth rate or just the MyPublisher contribution in 3Q?

Jeffrey T. Housenbold

Sure. So we had a very strong AOV uptick in the quarter of about 16% and that was driven largely by the lapping of Kodak in 2 ways, Paul. One was as we welcome those consumers onto the Shutterfly platform in mid- to late-Q3 last year, we did a number of promotional activities, i.e. free product to get them to transact and learn the Shutterfly platform. And since we weren't repeating those this year, that had a benefit. The MyPublisher, transactions at a typically higher average order value than Shutterfly because they only sell photo books, contributed somewhat to that increase as well. But it was largely a lapping of Kodak. Along with continued upsell and cross-sell, we launched new 10x10 and 12x12 books. Our premium content and other upsell improvements in the card has driven AOV. And it's a balance between driving customers and revenue and driving AOV and profits. And we make those decisions depending on which quarter we are in and what we think the elasticity of marketing in that quarter. And we saw a really good marketing efficiency in the quarter. We had -- our customer acquisition was right around $11 a customer, so it continues to be below $12. With respect, about organic growth and MyPublisher, since we're now managing a more complex portfolio with 7 premium lifestyle brands and because it's becoming more difficult to ascertain exactly which brand is that customer because there's overlap, we're not going to be breaking out revenue or other metrics for any of our brands going forward. I think the important part is the total revenue growth and the expanded total dollars of EBITDA and free cash flow that the business spits out. We will continue to report our Enterprise separate from our consumer brands, but we're not going to be giving specifics. So for the last time, just on MyPublisher, they were largely in-line with our previous guidance.

Paul Judd Bieber - BofA Merrill Lynch, Research Division

Okay. I was wondering if you had any quick comments on the Google announcement today about kind of the enhanced photo features of Google+?

Jeffrey T. Housenbold

Yes, we were pretty aware of where Google was headed with their acquisition of Nick and Snapseed and the improvements that they're trying to make to Google+. I think there's some similarities to what they're doing, what Apple is trying to accomplish through iPhoto and what Shutterfly is trying to accomplish through our ThisLife. And it's all about how do you get more pictures onto your ecosystem and how do you help people share those pictures. I think what differentiates us from iPhoto and from Google+ is a couple of things. One, we're not trying to be a broad, open social network around photos. We're really trying to be a platform for memories, that's more closed, that helps people interact with people that matter most to them, and to protect and preserve their precious memories. The other important aspect is that we're ubiquitous across operating systems. So our ThisLife service not only works on Android and iOS, it works on Kindle devices. It works on a PC and it works on a Mac. It takes in pictures from sources like Dropbox and Flickr and Picasa and SmugMug and your hard drive and your phones. So we're really positioning our service to the tens and tens of millions of Shutterfly users and new customers, really centered descended around memories, around security, around the ability to manage your ever-growing array of personal content versus managing a social network. So we think we're very well-positioned for -- with our ThisLife beta and we're excited about the new features and functionality that will add over the ensuing few quarters as we move from beta to a full-blown launch.

Operator

The next question comes from Kevin Kopelman from Cowen & Company.

Andrew Marok - Cowen and Company, LLC, Research Division

This is Andrew Marok on for Kevin. On the mobile front, I was wondering if you could give us a little color on the percentage of customers or orders you were seeing from mobile? And if you could expand if you're seeing any differences in AOV between mobile and desktop customers?

Jeffrey T. Housenbold

Yes, we're not going to be giving out the specific metrics, but I think I would say a couple of things: one, you heard Brian in his prepared remarks that the percentage of revenue coming from mobile on the Shutterfly brand increased from approximately 5% to 7% Q2 to Q3. And the average order value in general coming on mobile is lower than the website primarily because, on a smartphone, you're not making elaborate products like our award-winning photo book line, right, which has some of the highest, if not the highest, average order value of the products we sell, canvas prints and our large photo books being the 2 highest. So the AOV is lower, but not meaningfully lower. And what we're seeing is both adoption by existing Shutterfly Inc. customers, but we're also seeing now mobile being a rather effective acquisition tool for new customers to our ecosystem. So we're very pleased with the efforts in mobile. There's still a lot more that we have planned throughout 2014, but if you look back just 18 months ago, we had nothing in mobile. And today, we have 9 different apps across 3 different operating systems driving an increasing number of interactions and revenue and profit. So very excited about mobile.

Andrew Marok - Cowen and Company, LLC, Research Division

All right. And if you have it, just the percentage of revenue that came from existing customers in Q3?

Jeffrey T. Housenbold

It's roughly consistent with the past. It was about 2/3, 1/3.

Operator

The next question comes from Shawn Milne from Janney Capital Markets.

Shawn C. Milne - Janney Montgomery Scott LLC, Research Division

Jeff, just a couple of quick questions. First, just on the Costco termination. You mentioned about continuing partnership. I mean, is there any other or can you remind us what other lines of revenue may be at risk? And then it sounds like given what took down, the bottom line relative to the top line, obviously, this was a lower-margin business. And then secondly, just going back to the mobile questions. I know it's kind of early in terms of iPad creation for photo books, but given Apple's recent announcements to do more photo book on some of their own iPhoto applications, what are you seeing along that front? Are you seeing any decent consumer adoption of your own photo book creation?

Jeffrey T. Housenbold

Sure. We have a number of aspects to our relationship with Costco and, as I said, on the first question from Youssef, we're very pleased with our relationship with Costco. They asked us if we would have a lower price point card for the holiday for ship-to-store. And what we decided was we didn't want to provide a lower price point and lower our quality and our substrates or damage the long-term viability of the premium TinyPrints brand. We still have relationships with TinyPrints for ship-to-home, and we have relationships with Wedding Paper Divas. And so this aspect, it was late in the quarter, it was about $8 million of anticipated revenue in our fourth quarter, we've decided to remove that from the guidance carryover the $5 million and upside from Q3 reducing the top end by $3 million. So we'll continue to work with Costco and continue to seek ways to expand out business, but we're going to do it like we've done in the past with other large partners, Yahoo!, Best Buy to name a few, that it has to be a win-win. And in this case, we decided to take the long-term view on the brand. With respect to Photo Story and iPad Creation, we're seeing very nice adoption of our app, and as people are getting accustomed to using it, the difference of that experience versus a desktop, we're seeing good conversion rates, we're seeing increased downloads, we're seeing increased revenue and it will be interesting to see how the tablet experience plays going into the fourth quarter.

Brian M. Regan

And Shawn, this is Brian. One other point or color on the Costco relationship, the remaining component of the relationship right now that is ship-to-home is a much less substantial amount of revenue that we are driving from that or expecting from that versus what we had in the ship-to-warehouse program that's been terminated.

Shawn C. Milne - Janney Montgomery Scott LLC, Research Division

Okay. And lastly just on ThisLife. When do you think you're -- Jeff, why don't you put a little bit of -- I understand you're still in the beta phase? But when do you expect to fill the weight behind the rollout?

Jeffrey T. Housenbold

First half of 2014, we're going to add a -- there's between a dozen and 2 dozen other features and capabilities that we want to add to it. The teams are working incredibly hard to do that. We're also doing it at scale, right, and that's the key here with more than 20 billion images on our platform today. We're making sure that it works across multiple platforms, adds to the complexity, works very quickly and is a very intelligent piece of software. So we're excited about what the future hold as we enter in the first half of '14.

Operator

The next question comes from Scott Devitt from Morgan Stanley.

Stephen Shin - Morgan Stanley, Research Division

This is Stephen Shin, on for Scott Devitt. A couple of follow-up questions to some of the questions that have been asked before. You guys mentioned that there was a shorter holiday season. I mean, how do you think the shorter holiday season will impact the kind of promotional cadence in Q4 in the marketplace? And then second, Treat has been out there and it's certainly seen some nice growth, I mean, if you have any update on the growth rate? And then whether or not -- when Shutterfly will be ready to invest hard marketing dollars behind it?

Jeffrey T. Housenbold

Sure. So the 6 shorter days is interesting. There were 6 more days last year, and I think a lot of retailers expected people to come out earlier, but the consumer waited and waited and procrastinated in a very typical fashion, but you've seen across retail everyone pulling forward their promotions and sales this year. A lot of buzz around Kohl's and Macy's and other folks opening the night of Thanksgiving. So I think a lot of people have uncertainty as to what the specific behavior consumers will be. In our business, since it's a custom-build product, right, made on demand, it means that we have to provision for more capacity for those peaks. We did that through purchasing additional equipment and by expanding our outsourced partner network. We also expanded our customer service capabilities because the orders are going to come in a more narrow window. So we're very prepared for that, and I think given our scale, it actually creates a competitive advantage to us because we can fulfill and deliver on the SLAs for our customers and given our manufacturing footprint and things like Super Rush Plus, we're even going to differentiate ourselves further in the marketplace. So I think in general, the promotional activity people will pull forward a couple of days earlier than last year to try to lock in some sales. With respect to Treat, as my previous comments, we're not going to be breaking out growth rates of any of our 7 premium lifestyle brands, but we're pleased by the trajectory of Treat. We saw a very healthy revenue increase. We saw improved conversion rates. We're seeing more -- a higher AOV. So the trajectory is good. It's still on a relatively small base. And -- so we're going to continue to market mostly within the family, if you will, through cross-sell before putting real hard marketing dollars because we think there's a long runway to get adoption across Shutterfly Inc. customers first. And then I think those were your questions.

Operator

The next question comes from Aaron Kessler from Raymond James.

Aaron M. Kessler - Raymond James & Associates, Inc., Research Division

A couple of questions. First, following up on Mr. Bieber's question on the customer growth, the 6%, I think you referred to Kodak. With the decline of 6%, was that mostly higher promotional growth last year from Kodak and maybe if you have a rough normalized number for that? And then maybe the puts and takes as we think about margins going into 2014?

Jeffrey T. Housenbold

Sure. The deceleration in the growth of customers was largely due to Kodak. We're not going to be breaking out the specific amount. And also remember, when we give a free product, customers often pay for shipping and so they get counted as a paid customer. So they might have gotten 100 free prints or free photo book or a free calendar and paid us a couple of dollars in shipping, and they get counted as a paid customer. We had a lot of that type of promotional activity last year for the Kodak customer base that we didn't repeat this year. So that was dampening the customers and orders. We also made a strategic decision through our product assortment and promotional to drive average order value and profit. And you saw our nice beat [ph] on the EBITDA line in the seasonal strong -- seasonally low quarter preserving our marketing dollars for the seasonally strong fourth quarter. As we look into 2014, there's a lot of puts and takes to our margin. I think on the last call, we talked about the relocation of our data and colo [ph] facilities from the Bay Area to Las Vegas and the need to keep both of those facilities lit until we get past Q4 of 2014. That's going to be the single largest drain on our margins. Second, as you know, we're opening Shakopee, Minnesota, and so there's some drain on our margins as we ramp that up. But we're also seeing very nice in-sourcing, for example, in Q3, on Tiny Prints. So I think we went from somewhere around 30%, 35% of in-sourcing to something near 70% to 75%. So as we light up these new facilities, we bring more Tiny Prints production onto our system as we bring in-house more specialized gifts like we've done with our iPhone and Galaxy cases, you're going to see margin expansion, and then the size of the platform, the scale and scope economies in terms of shipping, improvements in customer service, in our materials, in our waste and our training. So lots of good things are happening. So as I look beyond 2014 into '15 and '16, I see a reacceleration, all other things being equal, to our EBITDA margins.

Brian M. Regan

And Aaron, it's Brian. I think as a proof point to Jeff's last comment around gross margins, our guidance for Q4 of around 60% to 61% of gross margin is in line with our historically high Q4 of last year, and that's even as we absorb additional acquired intangible amortization from our acquisitions and the scale-based depreciation from our new and expanded facilities and our in-sourcing equipment. So those investments are certainly paying off and we've guided as such for Q4, and that should continue into 2014.

Aaron M. Kessler - Raymond James & Associates, Inc., Research Division

Great. And just quickly, I realized it's early, but any thoughts on the promotional environment as we go into Q4?

Jeffrey T. Housenbold

Well, pretty consistent as it's been for the last few quarters. I think with the go-private American Greetings and Cardstores, a much smaller competitor, relative to our online offering. Snapfish would be the next biggest and then you have the traditional retailers at Wal-Mart, Walgreens, CVS, Costco, but we're playing at a more premium upper end with our core brands of Tiny Prints and Shutterfly. So we feel really good about what's in our control in terms of the products, the services, the lineup, our ability to execute, so I'm excited going into the ninth, Q4.

Operator

The next question comes from Victor Anthony from Topeka Capital Markets.

Victor B. Anthony - Topeka Capital Markets Inc., Research Division

You called out a few macro events behind unemployment, consumer sentiment, budget negotiation. So did you see an impact, I guess, late September from those events that would lead you to call them out for the fourth quarter for you to be cautious? Second, what would get you to act more aggressively on your share repurchase? And third, maybe you could give us an update on your hands up [ph] cloud services and the timing of the launch?

Jeffrey T. Housenbold

Yes. So we delivered our third quarter that was above our guidance range both on revenue, on EBITDA and on profitability. So we had a very solid Q3. It's hard to ascertain the specific impact from this -- the government furlough, but we've been calling out if you look over the last 30-plus quarters, yes, about 30 quarters, we've been calling out various aspects of the macroeconomy, certainly since the great recession. So there's nothing remarkably different, but you're seeing consumer sentiment being soft. You've seen a lot of uncertainty into -- of the economy and so we're calling those out as potential risk factors here in the fourth quarter. In terms of the share repurchase, I think what we've said is that we went out and raised the convert to put firepower on the balance sheet to do disciplined, smart, strategic acquisitions and I think that will be our first priority for the cash. Remember, we did a concurrent buyback with the convert offering and that reduced our flow. So I don't see any meaningful shift in the cadence of repurchase versus M&A going forward in the next few quarters. With regard to your third question, we launched ThisLife about 10 days ago in beta on the site. We've had thousands and thousands of customers download it, use it. The feedback has been really strong, and we're excited about the enhancements to that service over the next few quarters as we move from beta to a full product launch.

Victor B. Anthony - Topeka Capital Markets Inc., Research Division

And a follow-up -- sorry, if I may ask -- I jumped in late onto the call. So international has been somewhat of an overhang, but an issue in terms of being able to expand there. Maybe you could give us an update in terms of how you're thinking about that going into 2014?

Jeffrey T. Housenbold

Yes, I'm not sure why it would be an issue or an overhang. I think the addressable marketing in the United States is quite substantive and still very low penetration of online from offline and with us as the meaningful market leader in that space. There is lots of opportunity for us to get leverage and scale, continue to grow our revenue and profit here in the United States, and we're doing that now through 7 premium lifestyle brands. Having said that, our desire and goal as a company is to be a global company, and we have actively evaluated a number of international opportunities. But as you know, it's difficult to -- for any U.S. e-commerce or Internet company to be successful in Asia as a standalone or in Latin America. So that leaves you Europe, and Europe has been in an economic malaise for a number of years, making the relative growth rate to the United States that much more attractive. And so we've been putting our efforts and our resources to work to expand our market share here in the United States, but we desire to be a global company, and we'll continue to evaluate on a case-by-case basis.

Operator

The next question comes from Colin Sebastian from R. W. Baird.

Colin A. Sebastian - Robert W. Baird & Co. Incorporated, Research Division

Maybe a follow-up question on the use of cash, and you mentioned M&A again. Perhaps, the timing, what kind of deals you're seeing now in the pipeline or the profile of what you're looking for? And then secondly, more of a conceptual, I guess, question. One thing Google talked about today and other companies have talked about related to the photo market is machine learning, and I think more specifically, that's facial recognition and the related technology. I wonder, is that important for Shutterfly to be able to do or to match some of that functionality or from an end market's e-commerce perspective, is that not really relevant from where you guys sit?

Jeffrey T. Housenbold

Sure. On the M&A front, our profile hasn't changed. We look for consumer-facing companies that have a strong value proposition, a strong team with a similar cultural makeup, who care about delighting, their customers and have a history of innovation. We also really like companies that have real revenue and real profit. So year-to-date, we've evaluated 89 potential M&A activities, and we have announced 3 of them: MyPublisher, R&R and most recently BorrowLenses. As you guys are well aware of, markets are trading at historical highs. You're seeing $3 billion and $4 billion valuations on companies without a single dollar of revenue and that is trickling through into venture capitalists and private equity and founders' minds that they want multiples of 2015 and '16 revenue. Well, being a disciplined company, we're not going to be paying 40x 2016 revenue or 83x 2015 EBITDA. So the acquisitions we've announced have been very accretive, a, we're using cash; and b, we're buying things that have faster growth rates and higher EBITDA with lower multiples than ours. So we're going to continue to be very focused, very disciplined and very careful stewards of the cash on our balance sheet. With respect to machine learning, we acquired Photoccino out of Israel coming up on 2 years ago. We have that team plus other teams throughout the company, some in New York in our mobile groups and some here in our core engineering groups that have machine learning and algorithmic backgrounds, and we deployed a number of those into ThisLife to date and what we will be launching in 2014 will take that to the next level. So I think it's an important component, but I wouldn't overplay it. I think there is what I'll call the 80-20. There's a set of features that you need to have that benefit the customer, and then you could kind of get crazy on doing other things that sound good in a press release, but really are not meaningful to the end consumer nor generate revenue. So we'll continue to invest in machine learning and proprietary algorithms and delighting the customers, but all with a bent towards generating real revenue and profit.

Operator

The next question comes from Chris Merwin from Barclays.

Christopher Merwin - Barclays Capital, Research Division

So I was wondering if you could talk a bit about your branded advertising strategy? I mean you obviously have a very loyal customer base right now, but how important is it to invest in your brand going forward to help expand the category? Are you more focused on acquiring customers organically right now? And then secondly, I know email marketing has historically been the channel you've used a lot. Have you seen any impact yet from the Gmail filter changes? And how, if at all, do you think that will affect your marketing strategy going forward?

Jeffrey T. Housenbold

Yes. So we take a balanced approach between what we call free and paid customers. And we benefit, unlike some other e-commerce companies in some of the virility built into our business. So when a customer sends 200 holiday cards. And it says on the back Tiny Prints or Shutterfly, or it gives a unique calendar, a photo book, any of our other gifts, they're implicitly endorsing Shutterfly, and that has been a powerful acquisition tool for us. We also, through our photo sharing both ala carte, as well as our share sites, that is also another kind of organic way for us to acquire customers. And then through our more than 100 co-marketing partnerships with everyone from Target, to Coca-Cola, to David's Bridal, we have lots of other premium brands in the marketplace that are endorsing and introducing us to their customers as well. On the paid side, it truly is an integrated marketing approach between TV, radio, print, catalog and then online banners, buttons, mobile strategic partnerships and then lastly, email. So that fuel mixture has been working for over a decade and our acquisition costs remain below $12. So we're going to continue to execute on a proven strategy. Though we do think building awareness of the category will help us as a meaningful market share leader of the online component, which is still a minority of the total economic rents occurring in this community. As it relates to email marketing, we haven't really seen any meaningful impact from the Gmail filters. I think consumers got used to pretty quickly that there's -- their promotional activity-based emails are in one folder and it hasn't really impacted us.

Operator

The next question comes from Heath Terry from Goldman Sachs.

Heath P. Terry - Goldman Sachs Group Inc., Research Division

Great. Jeff, just curious, with the launch of ThisLife, where would you say the beta is right now in terms of what you have envisioned for Shutterfly as a cloud product and as the service evolves, how do you see kind of the branding and the more proactive launch of the service out to the user base to look?

Jeffrey T. Housenbold

Yes, it's a good question. So I think to start with, we're very ambitious in what we think the product can do. And so I would say we're about 1/3 of the way where we want to be, and I think we will make a meaningful progress in the first half of 2014. I don't think we'll ever be done because we'll continue to add feature functionality, but by the end of 2014, we should be 90% with the initial vision and then that vision will expand as users use it and we continue to invest in it. When we exit beta, and you don't have to be at 90% to exit beta, but we thought being higher than 1/3 was important, you will start to see us do hard marketing through a number of the integrated marketing channels I just mentioned on the previous question and through partnerships. We think this is a really unique product and that it's ubiquitous across operating systems. It's focused on memories, not photos, in that it's best-of-breed in the marketplace. And so we think there'll be some interesting partnership opportunities as we move forward as well.

Operator

The next question comes from Trisha Dill from Wells Fargo Securities.

Trisha Dill - Wells Fargo Securities, LLC, Research Division

I just had a question on really improving the ordering experience for the consumer. You've talked a bit about how you've incorporated the technology from your recent acquisitions into creating photo books and other products, which has reduced some of the frictions in that process, but is there a way to quantify the progress you've made there on improving the process? Or can we just estimate what inning you're in here? Maybe it's the amount of time a user spends on the site, creating a book and maybe that's gone down or maybe customers are ordering larger books or they're less dependent on customer service? Any detail you can provide there would be helpful.

Jeffrey T. Housenbold

Yes, I think the specific details will be -- we certainly look at a lot of funnel metrics internally, but we haven't ever disclosed those, so I'll be more general on that. But it's kind of not a static thing. As you -- if you look back 5 or 6 years ago, people had largely just a point-and-shoot camera and the volume of digital photos was relatively low. Today, they have a camera with them all the time annexed to their smartphone and the volumes are increasing. They also have a digital SLR. They have a point-and-shoot. Their kids have iTouches or iPads, and so the volume of photos are increasing and what you have is the traditional paradox of choice. Particularly, given that a majority of our customers are moms, she makes it -- it's hard for her to say, "Wow, this picture of my kid is better than this one," or "I have to cut out my second kid out of this photo." And so the paradox of choice comes into play. So you've seen us do a lot of different things using Simple Path, using Photoccino, our new Magic Shop, Share site intercepts. We're also using favoriting in selecting your Christmas card to reduce the choice. You see a lot of that in the new Photo Story on iPad. So there's a lot of different ways in which we're presenting a narrower but more premium offering to the customer and reducing the time to upload the photos, ThisLife is a great example of that, and then to kind of get into what she finds enjoyable, which is actually the creation process and the giving process. So I think the best way to think about that is just the increased volume of books and cards and calendars and photo merchandise that we've sold over the years as a key metric that says this is appealing to more and more people as we make it easier and smarter. And -- but we're not resting on our laurels. We have many investments. Some just rolled out in time for Q4 and many on the roadmap for 2014 that we think will further enhance the overall experience.

Operator

[Operator Instructions] The next question comes from Brian Fitzgerald from Jefferies.

Brian Patrick Fitzgerald - Jefferies LLC, Research Division

A lot of questions answered. I appreciate the thorough call. Quickly on -- are you seeing any unique dynamics around the various hardware your services are delivered on, be it tablet, PC or phone or maybe iOS versus Android? And then on ThisLife, I know it's early days still on beta, 10 days, are you seeing early indications that people are essentially product converting? They're bringing photos and aggregating stuff over from other products, competitive products, to ThisLife?

Jeffrey T. Housenbold

So I think our goal is to be ubiquitous for the customer because she now is on the screen. She goes from sitting in front of her PC to do a certain number of tasks, to waiting for her kids to come out of school on her smartphone, to sitting on the couch while they're watching a show, doing email and making a photo book on her iPad. So what we want to create is a ubiquitous environment where she could seamlessly move from device to device, operating system to operating system and allow her to interact with her photos, be more creative and stay connected with the people that matter most to her. And so that is our strategy and our goal. If you ask relative, we see more iOS usage than Android usage because our customer demographic skews higher per capita disposable income and it's largely a U.S.-based line. And so if you look at Apple's share across those metrics, it's fairly consistent. But we're seeing an uptick in tablet usage, as many other e-commerce players are, as the tablet is becoming a replacement for the PC. In terms of ThisLife, very early to say, but we are pleased by the number of people who have downloaded the app, who have uploaded photos, that the photos are coming from multiple sources. That the feedback they've given us about "Wow, this is cool, this is..." I had one customer email me today and say, "Please shut off ThisLife. It's become addicting. I can't get any work done." And so people are in there, tagging their photos, doing facial recognition, creating stories, sharing out and so the early adoption, again, early in beta, but very positive and we look forward to the continued investment and continued adoption of the ThisLife product.

Operator

The next question comes from Kerry Rice from Needham.

Kerry K. Rice - Needham & Company, LLC, Research Division

I apologize if the question's already been asked. But I wanted to kind of talk about BorrowLenses just for a second and maybe how that fits into the usage on video. And I think most people think of Shutterfly as maybe photos, but I think there's a great opportunity for video to be a growth opportunity for you guys. And I was just curious how you might see BorrowLenses fit into that growth strategy.

Jeffrey T. Housenbold

Yes, some of this has been asked, Kerry, but let me -- I think your twist on it is a unique one. BorrowLenses, over the last year, introduced video equipment, as well as high-end digital camera equipment, as more and more people are shooting very high 1080p video on their DSLRs. In fact, a number of movies and TV shows, like House, are shot on a basic Canon 5D Mark II video. So the quality is getting that much better, and now consumers are able to try before they buy or rent when they're doing a family vacation to Africa or to Hawaii, and so BorrowLenses helps the people take more pictures and video of their most important memories. Also with ThisLife, the service allows you to now interact with your videos, as well as your photos as people have more and more video on their smartphones. And what we do through our service is take it off the smartphone automatically with a background upload and it gets presented in chronological, you can tag an add place and people and other things. So we are making additional investments in video and the way to monetize that is through the subscription service of ThisLife. So we're excited about how BorrowLenses may allow more of that content to get on our ecosystem and also how ThisLife will help consumers interact with their video in a more interesting way.

Brian M. Regan

And Kerry, it's Brian. What I think is also interesting to note that in terms of video, as Jeff mentioned, some of those studios are BorrowLenses' clients. So it does -- the service does cater to consumers who want to take better photos and videos, prosumers, a mix of the both, and also just enterprise clients that are actually using the rental services to make their professional shoots a little bit easier.

Operator

And I am showing no further questions. I would now like to turn the call back over to the presenters for closing remarks.

Jeffrey T. Housenbold

Great. Thank you, everyone, for joining us on our Q3 2013 earnings call. As you can tell, we're very excited about the lineups of products and services across our 7 premium lifestyle brands and our ever-growing Enterprise business. We are best prepared for the fourth quarter than we have been in the history of the company. We're mindful of macroeconomic uncertainty and the loss of the Target revenue of $8 million in the quarter, but we believe that we are best positioned as the market leader to continue to help people share life's joy. So we will see you after the fourth quarter and update you on our progress. Thank you.

Operator

Ladies and gentlemen, that does conclude the conference for today. Again, thank you for your participation. You may all disconnect. Have a good day.

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