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Shutterfly, Inc. (NASDAQ:SFLY)

Q4 2009 Earnings Call

February 4, 2010 5:00 pm ET

Executives

John Kaelle – Vice President, Finance

Jeffrey Housenbold – Chief Executive Officer

Mark Rubash – Chief Financial Officer

Analysts

Shawn Milne – Janney Capital Markets

Imran Khan – JP Morgan Securities

Youssef Squali – Jefferies & Company

Jim Friedland – Cowen & Company

Mitch Bartlett – CraigHallum Capital Group

Kristine Koerber – JMP Securities

Colin Sebastian – Lazard

Jaren Schramm – Roth Capital Partners

Michael Olson – Piper Jaffray

Scott Devitt – Morgan Stanley

Operator

Welcome everyone to the Shutterfly fourth quarter and full year 2009 financial results conference call. Today's call is being recorded. I would now like to turn the call over to John Kaelle, Vice President of Finance for Shutterfly. Please go ahead.

John Kaelle

Thank you. Welcome to Shutterfly's fourth quarter and full year 2009 conference call. With us today are Jeff Housenbold, Chief Executive Officer of Shutterfly, and Mark Rubash, Chief Financial Officer.

A press release detailing the results is available on shutterfly.com, and an archived copy will be kept on our site. We have also released some visuals that we'll use as we go through the call. Additionally, within a few hours we will release a recording of this call both in a streaming online format and through a downloadable podcast. You can access all of these through the Investor Relations section of our website at shutterfly.com.

Before we begin, I'd like to note that our discussion today will include forwardlooking statements within the meaning of the Securities Act of 1933 and the Securities and Exchange act of 1934. These forwardlooking statements include statements about our business outlook and strategy and statements about historical results that may suggest trends for our business.

For more information regarding these risks and uncertainties that could cause actual results to differ materially from those expressed or implied in these forwardlooking 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 10KA and its other filings with the SEC.

I'd also like to note that any forwardlooking statements made on this call reflect analysis as of today. This presentation contains certain financial performance measures that are different from financial measures calculated in accordance with GAAP and may be different from calculations of measures made by other companies.

The quantitative reconciliation of these nonGAAP financial measures to the most directly comparable GAAP financial measures is available in our Q4 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, Jeffrey Housenbold.

Jeffrey Housenbold

Thanks, John, and welcome everyone. I will start today with a review of 2009 and then turn the call over to Mark to review our financial performance for Q4 and full year 2009 in detail and provide financial guidance for Q1 and full year 2010. We will then open up the call for Q and A.

As you listen to our remarks today, I'd like you to keep in mind three key messages.

First, I am very proud of the Shutterfly team as they delivered strong Q4 and full year results despite a tough macroeconomic environment. Q4 marked our 36th consecutive quarter of yearoveryear revenue growth, and we delivered the top line with record margins. Our strategic investments throughout the year, combined with our focus on strong execution, innovation, and improved efficiencies, led to record Q4 and full year financial results.

Second, we are addressing a number of multibillion-dollar markets that have just begun to be transformed by technology. By leveraging our unique set of assets, including our user facing webbased technology platform, strong brand equity, loyal customer base, integrated marketing capabilities, state of the art printondemand facilities, and IP portfolio, across these large markets we are well positioned for continued growth.

Finally, in 2010 we will continue to make appropriatelysized investments in our product and services offerings with increased focus on user experience, design, multichannel marketing, infrastructure, and other activities that leverage out manufacturing assets and active customer base.

We believe that these types of investments will enable increased market penetration with continued growth in the top line revenues, bottom line profitability, and free cash flows. With those three messages in mind, I will summarize our headline financial results.

Consistent execution across all key strategic initiatives, relentless focus on the customer, and strong financial discipline resulted in record financial results for Q4 and 2009.

During Q4, we delivered $131 million in revenue, representing a 22% yearoveryear increase. For the full year 2009, we increased annual net revenues by 15% to a total of $246.4 million. The key contributor to our success in 2009 was the continued growth in our line of personalized products and services, which showed 25% yearoveryear growth.

Now, I will briefly recap some of the tremendous progress we made throughout the year, starting with our products.

2009 was a strong year for our awardwinning Photo Book line. We extended our assortment by introducing new formats, cover options, styles, and layouts. Additionally, we made a number of improvements to the user experience which drove trial and repeat within the category. We also expanded our platform so users can share their Photo Books on Shutterfly share sites as well as popular social networking and blogging sites like Facebook, MySpace, and word press.

In Q3, we introduced Simple Path, our most significant Photo Book innovation yet. Simple Path enables oneclick creation and ordering of beautiful, designforward Photo Books. Our smart algorithm instantly organizes and arranges photos into a professionally designed Photo Book and, customers can order asis or personalized to their taste in minutes using 21 exclusive style templates and easy to use editing tools.

The introduction of Simple Path, combined with ease of use enhancements to our Custom Path, the introduction of lower price soft cover books, and our strong mix of marketing and promotional programs led to greatly increased awareness and trial of our Photo Books during the important Q4 holiday season.

Now turning to cards and stationery. We enhanced our cards and stationery collection to include an array of elegant personalized products that include baby shower, birthday, and baptism invitations, coordinating thankyou cards, graduation and moving announcements, bridal shower invitations, and wedding savethedates, corresponding thankyou cards and address labels, and calling cards, note pads, and custom gift packs.

We also updated our stationery creation paths, improving the customer experience and saving them time through our templatedriven approach that includes assistance or occasionbased etiquette.

Our stylish cards and stationery collection is comprised of exclusive designs from our internal design team, world renowned thirdparty designers, and leading charitable organizations like Live Strong and Special Olympics.

Throughout 2009, we launched thousands of new designs, ensuring that our customers had the perfect way to express themselves across a number of occasions, especially during the busy Q4 holiday season.

To make it even easier for our customers to create the perfect holiday card, we enhanced our 5 X 7 folded 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, stamp, and mail customers' holiday cards directly from our manufacturing facilities; and launched attributebased filtering to help users find the right card type and style.

Our comprehensive cards and stationery collection is making an impression on the industry and has received accolades from leading publications like People, Real Simple, Self, and Pregnancy Magazine and from top websites like Daily Candy, Martha Stewart Wedding, and Bazaar.com.

Throughout the year, we enhanced our Photo Gift business starting with upgraded canvas prints. We then launched new center stage posters and puzzles featuring Disney and Hasbro characters that coincided with movie premiers from the Jonas Brothers and Transformers. And in time for Q4, we introduced Star Wars, GI Joe, and Dorathemed products.

In addition to our compelling line of products, we continue to successfully grow our services offering with a focus on our share sites. The goal of Shutterfly share sites is to be the best place on the web where families, friends, and groups can create their own secure website, stay connected, and share their memories.

Our sharing platform combines the power and benefits of photo and video sharing, blogging, selfpublishing and social networking sites, combined with a sophisticated security layer and an easytouse interface. Based largely on customer feedback, we made hundreds of enhancements to our share sites during 2009 that increased site creation, user engagement, and monetization.

In addition, in time for the fall sports season, we launched our youth sports share sites to make it easier for parents, players, and coaches to have the best organized, most engaged, and memorable season possible. From a business model standpoint, share sites are driving customer acquisition and loyalty, product sales, and while still in the early stages, advertising and subscription revenues. Share sites adoption continues to be strong, and we ended the year with more than 1.7 million sites.

In Q2, we launched Shutterfly Video which makes it easy to privately and safely share video with friends, family members, and groups on Shutterfly share sites. Shutterfly Video enables users to upload and post video clips from their digital camera or camcorder to their own private or public Shutterfly share sites. Shutterfly video users can also send video email shares and post videos to Facebook right from the Shutterfly account.

We also introduced our video premium service, which offers unlimited video storage and high definition quality playback. In addition to share sites and video, we invested in the growing mobile marketplace, providing new ways for people to share their memories while on the go.

In 2009, we launched our first application for the iPhone and iPod Touch, allowing customers to view, share, upload, and preserve their memories for free while on the go. Users can also post their iPhone pictures directly to their Shutterfly share site. Adoption has been very strong.

Over 370,000 people have downloaded the Shutterfly iPhone app. Following the launch, we were ranked the number one free photo application; and we're listed in the top 100 of all free apps. Apple has featured Shutterfly for iPhone on the home page of the iTunes store, and customer feedback continues to be overwhelmingly positive.

In Q3, we acquired Tiny Pictures, furthering our investment in the emerging markets of social networking and mobile platforms. In December, this team launched Wink, a new service that combines realtime photo sharing with photo printing for the social networking generation.

Wink enables customers to create and share printed photo strips using pictures from iPhones and social networks like Facebook and Flickr. Photo strips can be delivered anywhere in the world for $2.50. Wink is available as a free iPhone app and through a fullfeatured website at wink.shutterfly.com. During the first six weeks, the Wink application was downloaded by nearly 165,000 people.

Now, moving on to our accomplishments in user experience, integrated marketing, and manufacturing. In 2009, we made significant progress improving our funnel conversion metrics. We launched a newlydesigned home page and My Shutterfly page, which positively impacted registration, retention, and conversion rates.

Other enhancements included a more focused shopping experience, optimization for search engines, better merchandising across our growing array of products, stronger call to action, and an updated apple iPhoto assistant.

We continue to take an integrated approach to our marketing efforts and in Q2 launched coordinated microsites for the new mom and bridal occasions with tips, tricks, and inspiration to complement our new stationery offerings. We also enhanced our promotion and CRM platforms, enabling improved targeting, and onetoone marketing messages that enhance relevancy, conversion, and yield optimization.

To drive greater awareness and increased customer acquisition early in the holiday season, we also implemented several direct to consumer programs including expanded Santa sittings, Shutterfly house parties, and the Shutterfly family photo shoot day.

Our effective public relations strategy continues to increase awareness for Shutterfly, and 2009 was another successful year. Through targeted outreach, we drove a 92% increase in positive consumer impressions in print, broadcast, and online media outlets.

We're featured prominently in top publications like Wall Street Journal, New York Times, Fortune, USA Today, Forbes, People, Real Simple, and Good Housekeeping. We are also featured on highlyrated TV shows like the Ellen DeGeneres Show, the Today Show, and the Martha Stewart Show. In addition, we receive numerous accolades for our products and services throughout the year.

Our Photo Book line was recognized by iParenting media and received a national parenting seal of approval. Shutterfly was also named overall winner for Photo Books from Good Housekeeping magazine. Shutterfly share sites received a national parenting center seal of approval, and Shutterfly was named to the internet retailer hot 100 list. And once again was named the market share leader by Info Trends.

Throughout 2009, we increased our presence and use of emerging social media channels like Facebook and Twitter to increase awareness, brand favorability, and customer insights. Our Facebook fan base is approaching the 65,000 mark. This is larger than some of our competitors who are spending significant marketing dollars in this channel.

To complement these efforts, we launched a Shutterfly blog, Picture More, in Q4 as a destination for inspiration, tips, and tools for new and existing Shutterfly users.

From a manufacturing standpoint, 2009 was another great year. We successfully shut down operations in Hayward, California; seamlessly opened a new stateoftheart facility in Phoenix to complement our Charlotte, North Carolina, plant; and drove continuous improvement in throughput, quality, and efficiency.

In addition, we made solid progress with our commercial print initiative, particularly given the tough macroeconomic climate and the early stage nature of the program. The team delivered $3.8 million in revenue while further developing our suite of products, services, and capabilities that will improve the business in 2010 and beyond.

Lastly, we continue to strengthen our organization by growing our talented base of employees and managers and adding new team members throughout the organization, including the addition of Neil Day as Chief Technology Officer and Brian Swette as a new board member.

In closing, despite the fragile economy Shutterfly made great progress in 2009. Our strong execution against the right strategy in these early and large markets paid off in record revenue and free cash flow.

In 2010, we will continue our momentum and work to extend our lead in the Photo Book, cards and stationery, and memory-sharing markets through innovation, design-forward products and services, customer friendly policies, and industry-leading quality. This approach, combined with our commitment to solid execution and financial discpline will enable us to maintain our record of increased revenue, free cash flows, and long-term shareholder value.

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

Mark Rubash

Thanks, Jeff. Before I begin my detailed comments, I would like to extend my thanks and congratulations to the entire Shutterfly team for their contributions to a very successful Q4 and full year 2009. Their dedication, innovation, and focus delivered an outstanding assortment of quality products and services to our customers and accelerating revenue growth, record EBITDA profitability, and record free cash flows to our shareholders. In short, I could not be more proud of our team or their achievements in 2009.

I will start my discussion today with some observations about our fourth quarter performance, followed by a review of our key metrics, and then a walk-through of this quarter’s operating results. I will conclude my comments with an overview of our initial 2010 financial guidance. Following that discussion, we’ll open the call for your questions.

As I’ve mentioned over the past two years, we are executing against a very difficult economic climate that continues to pressure consumer discretionary spending. While we have seen clear improvements in our business across 2009 and in our most recent quarter, we continue to believe that the economy and the early indications of recovery remain fragile.

Despite these challenges, we did see some real signs for optimism in our Q4 holiday season. We set quarterly records for visits, user registrations, unique uploaders, shares, customers, orders, average order value, and net revenues. Even more important, we saw accelerating year over year growth in every one of our key engagement metrics. Our success in this year's holiday season has clearly confirmed that our strategy of building a strong brand, knowing our customers, and driving innovation can deliver solid operating results, even in difficult economic environments.

So let's now go a bit further into our key metrics. During 2004, our key engagement metrics continue to show the familiar trends we have seen since early 2008 with modest activity during the nonholiday periods and strong performance during the peak holiday shopping days. Like most ecommerce companies, October and November trends were fairly consent with our Q3 patterns, with the period from Black Friday through midDecember coming in relatively strong.

For the full quarter, site visits, user registrations, unique uploaders, and image shares all showed very healthy yearoveryear growth with fairly consistent growth rates across the quarter.

During Q4, we had approximately 1.9 million transacting customers who generated nearly 3.1 million orders with an average order value of $42.40. This strong transaction activity translated into 18% yearoveryear growth in customers, 12% growth in order volumes, and 8% growth in average order value. The average order value improvement was largely the result of a continued shift in product mix from print to higher value personalized products.

Let's now move through a discussion of our reported results starting with net revenues. Net revenues for the quarter totaled $131.1 million reflecting 22% yearoveryear growth. The allocation of net revenues between new and existing customers was 27% and 73%, respectively, consistent with Q4 of 2008.

Net revenues for the quarter also included $1.2 million from our commercial print customers, consistent with our Q3 results and bringing the fullyear total for commercial print to $3.8 million. In terms of product mix, net revenues from prints and personalized products and services totaled 28% and 71%, respectively. Also, net revenues from 4 X 6 prints represented 7% of net revenues, down from the 9% revenue contribution in the prior year.

In terms of net revenue growth rates, total prints accelerated both sequentially and yearoveryear. Personalized products and services increased 29% yearover year, led by continued strong doubledigit growth in Photo Books as well as significant contributions from our designer cards and stationery collection and from our calendar products.

Moving to the cost of net revenues and gross margin, we reported a gross margin of 61% during Q4, consistent with the prior year and well ahead of our expectations. This strong margin performance resulted from several factors including improved product mix, labor efficiencies from both our Charlotte and Phoenix plants, and improvements in materials costs, partially offset by promotional discounts, lower shipping margins, and lower margin commercial print revenues.

Technology and development costs totaled $12.7 million for the quarter and include yearoveryear increases of $162,000 for depreciation, amortization, and stockbased compensation. Excluding these amounts, our technology and development spending increased approximately $1.6 million or 23% from the prior year. Roughly 2/3 of this amount is attributed to head count investments we're making to improve the depth and quality of our products and service offerings, with the balance primarily attributable to cost increases for power, colocation space, and bandwidth.

Continuing down the income statement, sales and marketing costs totaled $18.8 million in the quarter, representing 14.3% of net revenues, consistent with the prior year. Approximately 70% of the yearoveryear increase is associated with expanded online media, direct response, and partner marketing campaigns, with the balance primarily associated with the expansion of our internal marketing team.

While our Q4 customer acquisition costs increased about 4% from the prior year, these costs were more than offset by the improvements in average order value per customer.

General and administrative expenses for the quarter totaled $12.6 million or 9.6% of net revenues, consistent with Q4 after last year. Excluding stockbased compensation and credit card processing fees, which vary with revenue volumes, G&A expenses represented 5.4% of net revenues in the quarter, down from 6.1% in Q4 2008.

Quarterly G&A expenses included increases for employee compensation and office lease costs, offset by lower costs for professional services and outside contractors.

Continuing the discussion, adjusted EBITDA for the quarter was approximately $47.9 million, far better than our guidance, and a $9.3 million improvement from Q4 of last year. This continued growth in EBITDA profitability resulted from increased demand for our products and services, improvements in product mix, and consistent efforts to manage our cost structure in line with our revenue growth.

The effective tax rate for the quarter was 34.3% resulting in a full year tax rate of 37.5% which was within our guidance range.

On a GAAP basis, our net income for the quarter totaled $24.1 million or $0.88 per share based on 27.4 million diluted shares.

Now I'd like to provide some additional insight on our capital expenditures and on our cash investment and liquidity status. Capital expenditures during the quarter totaled $4.8 million, including $1.9 million for technology equipment and software; $2 million for manufacturing equipment and building improvements; and $900,000 in capitalized software development costs.

Cash and liquid investments at yearend totaled $132.8 million, and our investments in auctionrate securities had a fair value of $41.7 million. In addition, we continue to carry an asset valued at $6.2 million representing the estimated fair value of the UBS right, which is exercisable beginning June 30 of this year.

At December 31, 2009, approximately 75% of our auctionrate securities were triple A rated and 25% were double A rated; and all investments continue to pay interest on schedule.

We remain confident that the combined $180.7 million in available cash, investment, and auctionrate related balances are adequate to meet our current and future operating cash requirements. In addition, we continue to maintain a $20 million line of credit that is available through June 23, 2010.

To round out this part of the discussion, I would now like to summarize our full year 2009 results. Net revenues for the year totaled $246.4 million, a 15.4% yearoveryear increase. During 2009, we had 3.3 million customers that placed nearly 7.9 million orders with an average order value of $30.74. Net revenues from prints decreased 3% on the year and contributed 33% of net revenues. Revenues from 4 X 6 prints declined from 18.5% of net revenues to 14.5% of net revenues in 2009.

The fullyear revenue contribution from personalized products and services totaled 66% and reflected 25% yearoveryear growth. Finally, our referral fees from web loyalty declined as expected to approximately 2.5% of net revenues; and our commercial print initiative delivered $3.8 million or 1.6% of annual net revenues.

Despite the cost of closing our Hayward manufacturing facility and opening the Phoenix plant, combined with the revenue losses from 4 X 6 prints and referral fees, our fullyear gross margin held firm at 55%, consistent with each of the past 6 years. By carefully managing our operating costs and capital expenditures, we were able to make strategic investments necessary to grow and strengthen our business while at the same time increasing our EBITDA profitability and substantially improving our free cash flows.

Our fullyear EBITDA profitability rate improved from 18% in 2008 to 20.4%. Our capital expenditures declined from 10.7% of net revenues in 2008 to an alltime low of 7.2% of net revenues in 2009. This careful management of both the top and bottom lines delivered $32.5 million in free cash flows during 2009, an 108% increase from the $15.6 million delivered in 2008.

So, in summary, 2009 was another challenging, yet successful, year for Shutterfly. We significantly strengthened our product and services offerings and the connections with our customers. We maintained our strategic focus, gained new insights into our business drivers, and demonstrated the strength of our value proposition in tough economic times. Finally, we delivered on our commitment to increase profitability and free cash flows.

To complete my discussion today, I would now like to summarize our outlook for Q1 and the full year 2010 together with some insight on our underlying assumptions. Consistent with our historical trends, since the end of the Q4 holiday shopping period and continuing through this week, we have seen a normal seasonal moderation in our site traffic and order volumes.

While quartertodate growth rates are outperforming the relatively weak Q1 from last year, we expect that the current economic challenges will continue throughout 2010 and that our fullyear revenue growth rates and transaction patterns will be comparable to our experience in 2009.

In terms of the components of net revenues, we expect that we will see some improvement in nonholiday growth rates with more elevated increases around the traditional holiday and gift giving periods. We expect a consistent mix of revenues between new and existing customers with modest growth in average order values.

Finally, we expect a continued shift of revenues from 4 X 6 and other print categories to our awardwinning line of personalized products and services. With respect to our commercial print initiative, we continue to make steady progress with our Group O relationship and with a number of new customers. While still in the early business development phase, we believe that commercial print revenues during 2010 will likely range from $5 million to $7 million and have included this range in today's financial guidance.

Finally, I would like to note that our referral fee program with web loyalty will be discontinued effective March 31 of this year. As a result, we now expect that total 2010 referral fee revenue will be less than 1% of our fullyear net revenues and substantially less than the amounts recognized in 2009.

The expected impact of this change has been fully reflected in the Q1 and fullyear 2010 financial guidance provided in today's earnings release. In addition, we expect that our 2010 average order value growth will moderate as a result of the decline in this revenue source.

In terms of our cost structure for 2010, we remain firmly committed to our plan of increasing profitability and free cash flows and will continue our strategy of carefully balancing strategic investments for growth with the requirement for increased profitability.

With the recent trends of improving business performance, we have decided to accelerate a number of new technology initiatives that we believe will both increase the rate of innovation in our products and service offerings as well as significantly improve our longterm operating efficiency.

Most of these investments will be focused on our core technology platform and user experience, but will also extend to our CRM and other marketing and analytical systems. With these comments as context, I will now summarize our guidance for Q1 and the full year 2010.

Starting with Q1, we expect net revenues to range from $40 million to $42 million which reflects yearoveryear growth of up to 17%. We expect our GAAP gross margin to range from 45% to 47% of net revenues and our GAAP operating loss to range from a loss of $11 million to a loss of $10 million.

We expect our adjusted EBITDA will range between $0 and $1 million and our GAAP effective tax rate to range between 34% and 38%.

Finally, we expect the GAAP net loss per share to range from a loss of $0.27 to a loss of $0.23, based on approximately 26.2 million weighted average common shares.

Turning now to the full year 2010. We estimate that net revenues will total between $267 million and $277 million, reflecting yearoveryear increases ranging from 9% to 13%. Excluding the impact of referral fee revenues, this guidance reflects yearoveryear revenue increases ranging from 10% to 15%. We expect the fullyear GAAP gross margin to range from 53% to 55% of net revenues. Excluding the impact of referral fee revenues, this guidance represents a gross margin improvement of approximately 60 basis points over 2008.

We expect that our GAAP operating income will range from approximately $8 million to $15 million and that our fullyear 2010 EBITDA margin will range from 18% to 20% of net revenues. Excluding the impact of referral fee revenues, this guidance reflects an improvement of up to 1 percentage point in our EBITDA profitability.

The fullyear GAAP effective tax rate is expected to range from 34% to 38%. Also, at December 31, 2009, we had substantially utilized our federal net operating loss carryforwards. As a result, we expect to accrue taxes payable for federal purposes during 2010 and will begin remitting cash taxes beginning in 2011.

We continue to maintain net operating loss carryforwards for California tax purposes and do not expect to generate any significant California cash tax liabilities during 2010. We expect the fullyear GAAP net income per share to range from $0.18 to $0.33 per share based on 28.2 million weighted average diluted shares. Finally, we expect that fullyear 2010 capital expenditures will range from 7% to 9% of net revenues.

In summary, in light of the challenging economic environment and the fragile nature of the early signs of recovery, we believe that our initial 2001 and fullyear 2010 net revenue and profitability guidance are appropriately thoughtful given the current market conditions.

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

QuestionandAnswer Session

Operator

Thank you. (Operator Instructions) Your first question comes from Shawn Milne – Janney Capital Markets.

Shawn Milne – Janney Capital Markets

Very good job on the quarter. Just a couple of questions looking out to 2010. Maybe first with Mark. Just on the gross margin guidance. Now that we're starting to anniversary some of the startup costs in the Phoenix facility and you look like you're going to have higher mix of personalized products and services, is there a chance we start to see margins, gross margins, rise a bit in 2010?

And secondly, Jeff, if you think some of the new products you've released recently and the outlook for personalized products and services in 2010, what kind of growth are you looking for there? Can we see that business accelerate through 2010 with some of your new initiatives? Thanks.

Mark Rubash

So the first question on gross margin, as I mentioned in the opening comments, the guidance does reflect a modest increase in the gross margin after you exclude the impact of web loyalty. Following that, certainly improvements in mix towards PPS and in particular the Photo Book line could cause potential for increased margin. That's always dependent on the extent of promotional activity that goes on across the year. But early days for 2010, but we think right now this is probably a good place for guidance to start.

Jeffrey Housenbold

On the growth, we saw 25% growth in our PP&S for the full year of 2009 and roughly 66% of total revenue is now coming from that group of products. We're very delighted with the progress through 2009.

I think the initiatives we recently launched, particularly highlighting Simple Path, which is reducing the barriers to trial in Photo Book and which is a key lever to migrating the 450 million 4 X 6 print transactions that occur in America every year over to this richer format of a Photo Book made for you, using our proprietary algorithm, has a lot of potential to continue to drive broad adoption and certainly growth in both our top and bottom line.

The other initiative I think is the continuing investment we're making in the cards and stationery area and extending beyond just the holiday season into baby and savethedates and to invitations and also some of the personalized stationery products, mom my calling cards, address labels, etc. I think those two have the most potential to continue to drive the growth in the PP&S over 2010.

Operator

Your next question comes from Imran Khan JP Morgan Securities.

Imran Khan – JP Morgan Securities

Right now you have roughly $180 million cash on the balance sheet. So a big chunk of your market cap is with cash. What's the plan of use for the cash that you have? And secondly, as the economy recovers and the CPM prices go up, how do you think about the customer acquisition cost trend in 2010? Thank you.

Jeffrey Housenbold

Keep in mind the 180, that's at the end the quarter. We still have some of our Q4 bills to pay which we'll estimate around $25 million to $35 million. So the balance of roughly $150 million, we have about $42 million of that in the auctionrate securities. But certainly we have ample cash to operate the business. The primary use is really to expand the business both geographically into different vertical markets and perhaps additional technology tuckins through mergers and acquisitions.

As we have been disappointed over the past, we're very thoughtful about making sure we do the right deals at the right prices; but we're keeping that war chest for potential M&A.

In terms of CPM prices, we do think there will be a moderate improvement across the internet advertising landscape and that prices both on the CPC and the effective CPM prices will rise. But our cost of acquisition remains very low relative to many other players in the industry. The viral nature of our business through our Shutterfly share sites, the way you can share and post Photo Books across your social networking sites, the way people give out dozens and dozens of holiday cards reinforcing our brand and Photo Books, we think that over 2010 and in the foreseeable future, our acquisition costs will remain relatively low and that our payback period will remain between 1 and 2 transactions.

Imran Khan – JP Morgan Securities

Jeff, as a follow up, in terms of geographic expansion, I think if you look at some of the larger ecommerce companies, they have roughly half of the revenues come from outside U.S. Anything that is structurally challenging for you to expanding the business internationally other than building of printing facilities?

Jeffrey Housenbold

Nothing really structural. That's why we're so excited, very proud of what we've accomplished in 2009. But even more excited about what the future holds for Shutterfly in this industry in general. We're at such early days of market penetrations, both domestic as well as internationally.

We think being a global company provides growth for us over ensuing years, creating a manufacturing facility overseas is in the single digit millions. That's not a structural barrier either. It's really the balance between the build versus buy versus partner analysis that we're undertaking on a countrybycountry and regionbyregion basis and making sure that we do that in a way that has the appropriate return on investment and the appropriate harvest timeline consistent with other growth initiatives that we have on our plate.

Operator

Your next question comes from Youssef Squali – Jefferies & Company.

Youssef Squali – Jefferies & Company

Two quick questions starting with you, Mark. I want to go back to something you talked about, that's EBITDA margin for 2010. I think the assumption there is 18% to 20%. For a challenged 2009 you still did north of 20% and you came in at 20.4%. You talked about the referral fee as costing you about 100 [inaudible], which basically means that the increased investment is what ultimately is going to cost you more EBITDA margins.

Can you help us maybe quantify the EBITDA, the impact from these increased investments? Maybe just help us understand what those investments actually are? Then I have a follow up.

Mark Rubash

Keep in mind that the differential from web loyalty year on year from 2009 to 2010 can be in the neighborhood of $4 million to $5 million of EBITDA dollars. So, as I said in my opening comments, excluding that amount we do expect that we will see improvement in our core business in the course of 2010.

At the gross margin level, we do expect it's going to be relatively flat. In addition to the comments I made earlier, there's also an increased more dollars going to commercial on the gross margin line that has a lower gross margin but increases gross margin dollars. So there's a lot of moving parts in the gross margin line.

In terms of operating expenses, the biggest component of increase on a yearonyear basis, increase in spending, is in the technology and development. There are a number of product initiatives there that we're not prepared to go into detail specifics today, but I will say that they will have significant impact on just the overall architecture and user interface as well as our ability to innovate the speed of innovation going out in the future, as well as a number of things that we think will help further on both the capital intensity of the business as well as the marketing efficacy.

I think we're going to see some leverage on the sales and marketing. Potentially some continued improvements on G&A and the primary investments in the course of the year are in technology and, in particular, innovation that could help 2010, but certainly future periods.

Youssef Squali Jefferies & Company

Should we be thinking about some of these investments as you playing catch up with last year since last year was kind of tougher than most expected? Or is this meaning that 2010 will be a bulge kind of CapEx year and then it will smooth out in 2011 or is this just annual recurring stuff that we should just basically expect to hit the P&L?

Jeffrey Housenbold

I think I would categorize it more in kind of a leapfrog approach of where the current state of the industry is today. Certainly the last two years have been tough years from an economic standpoint. With the success or relative success we've had in Q3 and certainly in Q4, I would say our confidence in making the investments that will benefit the longer term or that confidence level is higher. In terms of CapEx, there's probably a little bit there just dealing with the growth that we've seen in Q4 and the expectations for this year Q4.

I would say if there's any catch up that is occurring in the numbers, there's a little bit on the CapEx side in 2010, but really on the operating side we really think it's investing for growth and investing for future efficiencies.

Youssef Squali – Jefferies & Company

Then lastly, Jeff. Maybe you can just update us a little bit on what you're seeing in the market place. You seem to obviously be growing faster in ecommerce certainly than your competitors. Maybe if you can talk a little bit about where, how you see yourself positioned today versus say a year ago.

In particular, if you can share with us any kind of market share numbers. I think you referred to some study in your prepared remarks, but quantification would be great, both on the Photo Print business and on the Photo Book.

Jeffrey Housenbold

I am really proud of the team in terms of focusing on the customer, understanding what they need today, what they will like in three years from now, and building what they don't even know they need today.

That constant innovation that has always been part of the DNA of Shutterfly continues to pay off. I think our singular focus in this industry where many of our larger competitors, the Kodaks or the Hewlett Packards or the WalMarts of world, they have their broad line businesses where this is just a small piece of what they do. Our relentless focus on innovation and the customer and quality is really what's driving our continued lead and our ability to outpace the competition.

As it relates to overall ecommerce, I think we benefited in this category that it's still the very early days of adoption. Certainly the proliferation of digital cameras has high penetration rates, but the adoption of personalized products and services where people are able to interact with their photo and video memories in a unique and creative way and then the preservation and the sharing of those is really in the early days and we think that bodes well for years to come for Shutterfly in this industry.

With respect to specific market share numbers, in my prepared remarks I was referring to the Info Trends study which came out in the July Time Frame that had us as the leader. My understanding is they're refreshing that report; and it should be out in the next 6 to 8 weeks. So that will become public and you guys will have that. We don't have a preview of what our market share numbers are, but based upon our own internal channel checks we believe we continue to take share from our competitors.

Operator

Your next question comes from Jim Friedland – Cowen & Company.

Jim Friedland – Cowen & Company

First question on some of the licensing payments. I just wanted to confirm that in Q1 it's the last payment you will receive, I think it's from American Greetings. And you are already done with the second licensing agreement, so you won't see anything in Q3 this year and so unless you sign up anything new, looking out at 2011, there are no licensing payments coming in.

I guess the second part of that question is will we see any more licensing payments like that? And then the second question is in terms of acquisition multiples. Have you seen multiples come down, not talking about the sort of small technology focused acquisitions, but some of the larger ones? Thanks.

Mark Rubash

So on the first, the licensing, you're 100% correct. We have one remaining installment from existing IP licensing. I can't comment on what the future will hold, but we do have north of 30 patents in this space; and we continue to apply and receive new ones every quarter. We keep a constant eye on the competitive landscape to protect our intellectual property.

Jeffrey Housenbold

Just to add to that on the first question, if you think about our guidance for the full your and you take out those IP payments and web loyalty, which both of those approximate 100 percent flowthrough, we're certainly getting leverage in the core business and we're very proud of that.

In terms of acquisition multiples, part of I think Imran's questions were about use of cash. We've been very patient because there still seems to be discontinuities in the marketplace between private and public companies and the respective valuation expectations. So we want to make sure we do the right deal strategically, you also pay the right amount for that so that's accretive to our shareholders as well as the acquired shareholders. So I do think there still remains an irrational gap between private and public.

On the public side, it's more rational because it gets marked to market. So that gets a little easier to do. We're patient. We're going to continue to focus on our strategy and execute against it and then be both strategic and opportunistic on the M&A front.

Operator

Your next question comes Mitchell Bartlett – CraigHallum Capital Group.

Mitchell Bartlett CraigHallum Capital Group

On the average order value, last few quarters there's been basically the same between new and existing customers. Any change of that in the fourth quarter given all the promotion you were doing for trial and what not?

Mark Rubash

No. It actually continues to stick to a very tight trend between the two categories. Nothing I would say that is significantly positive. Definitely not anything negative or deterioration of that relationship.

Mitchell Bartlett – CraigHallum Capital Group

And existing customers look like they came back in force. What has been the user experience this year that has caused them to come back so strongly in the fourth quarter? Is there anything you can add as far as did they try Photo Book earlier in the year and you migrated them towards a bigger offering in the fourth quarter? Anything you can add there.

Jeffrey Housenbold

Without giving too much way about secret sauce, I think it's a combination of the innovation in both the product, the physical product, and the user experience enhancements that we've made throughout Q1, Q2, and Q3. The introduction of Simple Path, lowering the barriers, and then those investments and innovation combined our integrated marketing.

There wasn't one program that stood out. It was really the combination of our partnerships, our trial program around cards and Photo Book, our catalog, our page search, our increases in investment in natural search. All that coming together. I think there was some pentup demand as people realized they survived the worst of the recession and kind of want to get back out there and communicate with their friends telling them they're doing well.

And so we saw very a healthy uptick in our cards and stationery business for the holidays. Then it seemed like the gift of choice was something that was personalized and unique and our Photo Books really filled that need in the marketplace.

Mitchell Bartlett – CraigHallum Capital Group

Can you help us on how big Photo Books are as a percentage of the personalized products?

Mark Rubash

We haven't broken that out mostly for competitive reasons. Cards and stationery and Photo Books are of roughly the same size, but Photo Books are growing quicker on an overall basis. Those two make up the vast majority of personalized products and services.

Mitchell Bartlett – CraigHallum Capital Group

Then finally, last question, video. Where are we in the timeline of videos? Is it ready for prime time?

Jeffrey Housenbold

I think we're still in the early adopter phase in that people are capturing more and more video, but it's being still stuck on their memory card or on their home computer. They haven't really thought about how to share those videos, what they can do with those in terms of an interactive mash up or even what they can possibly do in turning those into different products. Still in the very early adopter phase.

I think the type of relationship we have with Motion Box, which reduces our investment dollars and capital but gives us a sandbox to learn and understand customer needs, it's the right one matched up against the slope of that adoption curve.

Mitchell Bartlett – CraigHallum Capital Group

So unlikely to see a whole bunch of product innovation from you guys in video this year?

Jeffrey Housenbold

I think that's a fair statement. I think we'll continue to do what we've always done is match the investment against that adoption curve to make sure that the harvesting of any investment, the time period is short and as profitable as possible.

Operator

Your next question comes from Kristine Koerber JMP Securities.

Kristine Koerber – JMP Securities

A few questions. First, we looked back at fourth quarter. Was the promotional environment, was that better or worse than what you were expecting?

Jeffrey Housenbold

I think it was very consistent actually with 2008 promotional environment. I think we expected the competitors to do more on price because they haven't made the same investments in innovation and design and user experience throughout the year. We expected them to use the price dial a little bit more. Our expectations matched reality pretty closely.

We tried to balance our promotional activity to not only grow the top line, but also to deliver the increasing EBITDA free cash flow margins that we experienced. It was about right on our expectations.

Interestingly enough, if you segment that marketplace, we saw some of the niche kind of higher end players actually do a lot more discounting as they're finding that the market on the very, very top end isn't big enough to sustain the investments they've made. So they started coming down. But because of our reach, our user loyalty from our customers, and our scale from owning manufacturing, we were able to take share across the marketplace.

Kristine Koerber – JMP Securities

Look at the print business; you saw some modest growth in the print business in the quarter. If I recall correctly, the past few quarters, the print business has been down. What drove the increase?

Jeffrey Housenbold

What we've seen across 2009 is the unit volumes, despite the change in pricing, unit volumes have been continuing anywhere from the low single digits to midsingle digits, depending upon the quarter. In Q4, I think really is just the existing customer base driving, adding prints to their shopping cart and feeling very comfortable with the brand and quality that comes from Shutterfly. There wasn't anything unique or different that we were doing with prints in Q4.

Kristine Koerber – JMP Securities

What about what was going on with the competitor? One of your large competitors adjusting their prices up and down.

Jeffrey Housenbold

I think you saw Kodak cut prices and then reverse the decision in the fourth quarter. I think as we've said is we haven't witnessed price elasticity to the extent that I think others expected it to be there. So we kind of are maintaining the appropriate pricing to balance that revenue versus profit. We're using the profits that flow out of the 4 X 6 print business to reinvest in our personalized products and services category and innovation and new designs and to marketing.

So we see the 4 X 6 print business really as more in that milk the cow segment. And what was nice is that we continue to grow the market a little bit ahead, grow out the 4 X 6 print business a little bit ahead of the market even though we have a premium price position.

Kristine Koerber – JMP Securities

Then lastly, as we look beyond 2010, do you have goals, longterm goals, as far as revenue growth and EBITDA assuming 2011 is a more normalized operating environment?

Jeffrey Housenbold

We haven't communicated a longterm model. I think the comments Mark and I have made in the past, I think, remain true today. The focus on growing both the top line and the bottom line. We think CapEx in the midsingle digits is attainable over the longterm and sustainable. We also think EBITDA with a 2 handle on it is what we said in the nearterm.

I think we were able to achieve both of those a little bit ahead of schedule as the 2009 results showed. Guidance for 2010, taking web loyalty out, I think that would remain consistent. EBITDA and you see a slight uptick in the CapEx as a percentage, but the total dollars remaining the same. So I think we're getting leverage out of the model and as the adoption of this industry continues to grow and our leadership position in it, we think the dollars flowing through the top will start to flow and continue to flow to the bottom as you saw a significant increase in free cash flow in 2009

Operator

Your next question comes from Colin Sebastian – Lazard.

Colin Sebastian – Lazard

Since all the key metrics showed accelerated growth in Q4, I wonder if you can talk how that relates to increasing customer engagements and whether the efforts to keep your customers on Shutterfly sites longer, such the share mobile sites, if there's a corresponding increase in monetization of those users or if this perhaps is an opportunity looking ahead.

Jeffrey Housenbold

I think there's, as we look at the business, there are things that we kind of consider as competitive table stakes. And then there are things that are innovative and drive growth. Over time, things that were growth drivers become more adopted by the competition, and they become things that you have to do.

What we've demonstrated successfully is the ability to continue to outthink the competition and outinnovate. So things like share sites are an example of that innovation  things we're doing in mobile and social, I think we have a step forward. No one of those is driving a particular metric across the 5 or 10 KPIs that we look at.

I think they're all important in increasing daily consideration and increasing stickiness and increasing the number of transactions to average order value in the lifetime value to customers.

I think the growth of the overall industry, given where we are in the early days, is really the key driver of the longterm ability for us to grow the side of the franchise and then will continue to focus on modest improvements on yearoveryearoveryear in conversion rates and average order value.

But it's really about filling the top of the funnel, and we think we've gotten the storage platform, the manufacturing footprint, our overall capital intensity, the G&A, all in the right place that we think this can continue to, the business model can continue to, spit off increasing amounts of free cash flow.

Operator

Your next question comes from Jaren Schramm – Roth Capital Partners.

Jaren Schramm – Roth Capital Partners

Quick question. Could we get some color on the Simple Path? What has traction been like generally among customers? Do you have a rough metric for Photo Book purchases that were done using the Simple Path method?

Jeffrey Housenbold

We're not going to break out specifics about Simple Path for competitive reasons. But the performance is better than our expectations both on Simple Path and on Custom Path in the fourth quarter. That was something that was a nice surprise because there was potential for cannibalism. What we're seeing is that both are meeting different needs of different segments of the marketplace.

Overall Photo Books grew quite nicely. Overall products and services grew 25% for the full year and I believe 29% for the fourth quarter. Photo Books was the key to that growth. Really the ease of use, the way we think about design, the quality that comes out of our company because we own manufacturing, the timeliness in which we are able to deliver it because we're not outsourcing that awardwinning customer service. All that, plus the viral nature of the word of mouth that's getting out there is really driving the growth in that category.

So early days on Simple Path, but pleased with the results but equally pleased with our Custom Path as well.

Jaren Schramm – Roth Capital Partners

Having a year now worth of commercial print revenue, could you describe the reception from the marketplace in regards to the commercial print segment? And how you think you're faring versus your competition there?

Jeffrey Housenbold

We're pretty pleased with the results. We delivered $3.8 million in our first full year. The team learned a lot about what are the needs of the customers, how does that marketplace segment, where does Shutterfly rank against the competitors in terms of quality, price, service? And how do we refine our marketing message and which are the pockets of opportunity that best meet our core competencies?

Not only pleased with the financial results, but our learning curve. We moved up that learning curve quite nicely. The entire market in and of itself, as you know, broad based advertising, and certainly impacting the direct marketing industry as well, felt a lot of pain in 2009.

So what we saw was the elongation of the business decision cycle and the sales cycle as a result. We're expecting as the economy continues to stabilize and improve, as we continue to enhance the platform and the service that we're offering, that we'll continue to see momentum in that part of the business.

Operator

Your next question comes from Michael Olson – Piper Jaffray.

Michael Olson – Piper Jaffray

Just a couple quick questions on revenue mix. I will try to go one layer deeper on the personalized products segment. Any range you can give us for what that segment will be as a percent of revenue for fiscal 10 compared to the 66% that we saw in 2009?

Jeffrey Housenbold

Nothing specific today. I think if you look at the historical trends of 2006, 2007, 2008, 2009. And I think those are on our website. If not, we certainly can provide those. It's stuff we've publicly issued. I think that trend is important. I think what we said is we expect the trend to continue. We don't think 4 X 6 print will go away entirely. We don't think the print segment goes away.

We do think that the growth in the business will be primarily driven by PP&S and that the relative percent increases that you've seen over the last few years is probably a good barometer for forecasting for 2010.

Michael Olson – Piper Jaffray

So basically 5 percentage point uptick per year kind of somewhere in that range?

Mark Rubash

We're not going to provide guidance on that, but I agree with Jeff's comments about following. The best proxy is going to be recent historical performance.

Michael Olson – Piper Jaffray

Then as someone mentioned earlier, this was the first quarter in a while that we saw print revenue up and up 7% yearoveryear. Are you guys looking to grow that business or try to kind of wind it down I guess? The question I have should we expect print will be up yearoveryear in 2010? Does that have any impact on gross margin if we do see a reversal to growth there? Thanks.

Jeffrey Housenbold

Strategically, it's not something that we're planning on removing. I think it's part of the overall value proposition. I think it helps increase more frequency in daily consideration. But strategically over the long term, we believe that the 4 X 6 print has a lesser and lesser role to play in memory preservation, memory sharing, people's creativeness given the advancements in both front end web technologies and also back end printondemand technologies.

We just think the Photo Book, for example is a much richer canvas for people to tell their stories. And as we hit that inflexion point over the next few years in terms of awareness and adoption, you are going to see a dramatic increase in Photo Book adoption; and you will see a continued decrease in silver halide and 4 X 6 prints in the industry. Strategically, we're focused on that, but we're not planning on removing the 4 X 6 print.

In terms of we read all the industry reports and understand the forecast area around that, people are expecting kind of flat growth in the 4 X 6 print industry, which is kind of what their forecast was for the last few years. The total number of pictures increasing, but the percentage of capture versus prints continues to decrease and the industry has been relatively flat.

It's outpacing the industry with premium prices I think is a reflection of the overall value proposition we bring to the marketplace and our leadership position. But we don't have a specific forecast for 2010 to provide. Personalized products and services has a slightly higher gross margin profile than the 4 X 6 print.

Operator

Your next question comes from Scott Devitt – Morgan Stanley.

Scott Devitt – Morgan Stanley

Congratulations on exiting the referral business. I had two, if I could, the first one is just around Simple Path. You launched it on September 23 and the personalized products revenue accelerated by 700 basis points in the quarter. I understand you're not going to break it out in terms of its affect. I was wondering if you could just talk qualitatively around it in terms of it seems like there's a capacity to increase conversion rates of your customers on the initial upload of photos now.

Jeff, I think you mentioned reducing friction as one of the benefits of Simple Path. I was wondering if you had any positive effects on initial conversion rates and anything that can do to the marketing spend needs over time.

Secondly. As it relates to the referral revenue, I was just wondering the timing, March 31. Is that the expiration of the contract or was there any other reason for doing it on that date? Thanks.

Jeffrey Housenbold

In terms of Simple Path, it certainly added to our top line in the quarter. But interestingly, we didn't overly merchandise or market Simple Path because it was so new and we didn't understand the impact it might have on the business in the important fourth quarter. We actually emphasized our Custom Path books.

So the people who found Simple Path, and we certainly worked at it somewhat but it wasn't a focus, were people who were new to the category. I think it did its job. It was targeted at a segment of people who haven't yet tried Photo Books who either were unaware or intimidated or afraid of the time commitment or the price to get into the category. So defaulting to a soft cover Photo Book at a lower price point than people were expecting, I think, helped.

Again, it was a small part of the overall mix for the fourth quarter. So really the next two quarters will be more informative in that area. Not only on Simple Path, but we continue to make the Custom Path easier reducing friction points as well.

In terms of web loyalty, the relationship with web loyalty will end on 3/31 which is a little sooner than we had communicated in the past. The contract actually went through the end of 2010. But given the strength in the core business and the growth there, our ability to improve overall margins, and our desire to use that inventory to crosssell and promote our own products and perhaps to use more traditional sponsorship opportunities, it felt like the right time, given the strength in the business coming out of the fourth quarter and the full year.

So we decided to end that relationship a little bit earlier. The relationship was a good one. Web Loyalty was a very good partner over the last 3 and a half years. We were pleased with that relationship. The revenues and the profits we got allowed us to invest in the business and migrate and diversify the revenue stream beyond the 4 X 6 prints. I think it served its strategic value to us. Now we think it's the right thing for the business, and we have a stronger core business model that allows us to go in a different direction sooner than planned.

Operator

That concludes our questionandanswer session. I would like to turn things back to our speakers for any closing remarks.

Jeffrey Housenbold

I just want to thank you all for participating today. As we said in our prepared comments and in the Q and A, we had a fantastic Q4. The business fired on all cylinders. We had the right product marketed in the right way to the customers with the right value proposition.

We're going to continue to make the appropriate size investments throughout 2010, particularly in technology and sales and marketing to further our lead and to enhance our top line, our EBITDA margins, and also free cash flow. We look forward to updating you guys on our progress at the end of the first quarter. Thank you.

Operator

That does conclude today's conference. We thank you for your participation.

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Source: Shutterfly, Inc. Q4 2009 Earnings Call Transcript
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