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Shutterfly, Inc. (NASDAQ:SFLY)

Q2 2010 Earnings Call

July 28, 2010 05:00 pm ET

Executives

John Kaelle - VP, IR

Jeff Housenbold - CEO

Mark Rubash - CFO

Analysts

Imran Khan - JPMorgan

Sandeep Swadia - Jefferies & Co.

Mitch Bartlett - Craig Hallum

Michael Olson - Piper Jaffray

Greg Lazard - Lazard

James Cakmak – Sidoti & Company

Scott Devitt - Morgan Stanley

Operator

Good day ladies and gentlemen and welcome to the Shutterfly, Inc. second quarter 2010 financial results conference call. At this time all participants are in a listen-only mode. Later, we will conduct a question-and-answer session and instructions will follow with that time.

(Operator Instructions) As a reminder this program is being recorded. I would now like to introduce your host for today’s program Mr. John Kaelle of Vice President of Finance for Shutterfly. Sir you may begin.

John Kaelle

Thank you operator. Good afternoon and welcome to the Shutterfly’s second quarter 2010 conference call. With us today are Jeff Housenbold, Chief Executive Officer for Shutterfly and Mark Rubash, Chief Financial Officer. A press release detailing our results is available on shutterfly.com and an archived copy will be kept on our site.

We have also released visuals that we will use to speak out throughout the call. Additionally, within a few hours we will release a recording of this call both in the streaming online format and through a downloadable broadcast. You can access all of these through the Investor Relations section of our website at shutterfly.com.

Before we begin, I would like to mention our discussion today will include forward-looking statements within meaning of the Securities Act of 1933 and the Securities Exchange Act of 1934. These forward-looking-statements include statements about our business outlook and strategy and statements about historical results that may suggest trends for our business.

For more information regarding these risks and uncertainties that could cause actual results to differ materially from those expressed or implied in these forward-looking statements as well as risks relating to our business in general, we refer to you section entitled Risk Factors in the company’s last annual report on Form 10-K and its filings with the SEC.

I would also like to note that any forward-looking statements made on this call reflect analysis as of today. This presentation contains certain financial performance measures that are different from financial measures calculated in accordance with GAAP and may 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 second quarter 2010 earnings press release which is posted on the Investor Relations section of our website at shutterfly.com.

Now, I would like to turn the call over to Shutterfly's CEO, Jeff Housenbold.

Jeff Housenbold

Thanks John and welcome everyone. I’ll start today with an overview of our Q2 performance, and then I’ll turn the call over to Mark to review our financial results in detail and provide our updated guidance for Q3 and full year 2010. We’ll then open the call to your questions.

As you listen to our remarks today, I’d like you to keep in mind two key messages. First, we continue to see solid growth and increasing contributions from our award winning lines of personalized products and services and I am particularly pleased with the strong performance of Photo Book, cards and stationery during the Mother’s Day and Father’s Day periods.

Our commitment to innovation, designed for our products and services, customer friendly policies and industry leading quality, once again delivered high customer loyalty and record new customers. Second, as we prepare for Q4, we will continue to make appropriately sized investments in our products and services offerings, customer insights and analytics, and other activities that leverage our manufacturing assets and active customer base.

We believe that these types of investments will enable continued penetration in our key target markets and continued growth in top line revenues, bottom line profitability and free cash flows. With these messages in mind I will now summarize the second quarter headline financial results. Consistent execution against our key strategic initiatives, relentless focus on the customer and strong financial discipline resulted in record financial results for the second quarter.

Q2 marked our 38th consecutive quarter of year-over-year revenue growth and we delivered the top line with better than expected margins. During Q2, we delivered $46.8 million in revenue representing a 20% year-over-year increase and a 25% growth rate excluding referral fees. Our strong performance was fueled by continued growth in our line of personalized products and services which grew 34% year-over-year or 42% excluding referral fees.

Now I will briefly recap some of the progress we made during the quarter starting with our products. In Q2, our photo book continued a strong momentum delivering outstanding results during the Mother’s Day and Father’s Day gift giving periods.

During the quarter, we introduced a number of new Photo Books features that further differentiates us in the category and let our customers create compelling products with their photos regardless of the store’s location. For example, we enhanced our local picture access functionality allowing customers to use photos right from hard drives further reducing barriers to try. We also added more intelligence to our simple path algorithm including the ability for customers to make a photo book in less than five minutes.

We also introduced a feature that allows users to create simple pass books using their own or their friends Facebook photos. By copying to the Facebook social graph users can create and order Shutterfly's award winning Photo Books in just a few clicks. And finally we have partnered with Sony to give customers instant access to Shutterfly's Simple Path Photo Books on new Sony VAIO computers broadening the awareness and potential adoption of our Photo Books.

Turning now to cards and stationery, we continue to improve the customer shopping experience and expand the breadth and depth of our cards and stationery collection. During Q2, we enhanced our (actively) based navigation making it faster and easier for customers to find the perfect card across such elements as cards format, number of pictures, paper type, cards size, card color, designer and price.

We launched the new sophisticated 5x5 square foam chapter across new locations in our stationery collection and we enhanced our 3x5 folded milk products by adding more design and layout options. Finally, we continue to broadening our occasions, adding summer parties, moving announcements and Bar and Bat Mitzvah cards.

In addition to our product enhancements, we also improved and launched new capabilities through our key services during the quarter. On our baby theme share sites we added features to get new and expecting parents new ways to sharing important milestones with friends and family. For example, we introduced a baby share site creation wizard that helps customize and simplify the creation experience. We launched the baby widget, it allows parents to chronicle and easily share major milestones and everyday moments during that baby's first year.

And we created 12 new baby share site designs and coordinated with our birth announcements allowing new parents to celebrate their baby's arrival in style. On our wedding share sites, we've partnered with The Knot and Wedding Channel to introduce an integrated gifts registry tool. This feature makes it easy for brides and grooms to integrate gift registries into their share site making to get one stop personalized definition for wedding memories and instrumentation sharing with family and guests.

Other new share site enhancements include improved tagging and clustering features that make it easier for groups to review and water photos water and an expanding interface for creating an order in the personalized products and photos. Our share sites continue to provide a unique and competitive offering to that provides customer acquisition, product sale and user royalty. Adoption of (inaudible) like share sites continues as evidenced by the more than 2.1 million personalized photo rich and engaging site that were created by the end of the second quarter.

Moving on to non-share services, in June, we made further enhancements to our video posting service. As part of this upgrade we switched partners from Motion Box to source media because they were able to offer greater performance, stability and an incurred overall user experience. On the integrated margin front, we kicked off some information and partnered with Old Navy for our summer freedom photo contest. The consumers can access inspirational solutions to help them celebrate and commemorate summer stories through Photo Books, share site and other Shutterfly products.

Additionally, our social media efforts continue to yield high levels of customer engagement on the Shutterfly blog, Facebook fan page and Twitter page. In closing, we ended the first half of 2010 with strong momentum in our key product and service offerings and we continue to execute on our strategy.

We will continue our efforts to gain market share through innovate and design forward products and services, customer spending policy and industry leading quality. This strategy combined with our commitment to solid execution and financial discipline will help us deliver increased revenues, free cash flows and long term shareholder value.

With that I’ll turn the call over to Mark to review our financials in detail, Mark?

Mark Rubash

Thanks Jeff. I will start my discussion today with some observations on the current economic environment followed by a review of our key metrics and then a walkthrough of this quarter’s operating results. I’ll conclude my comments with an overview of our updated 2010 financial guidance.

Following that discussion, we will open the call for your questions. Consistent with many of my past comments, we continue to execute against a very difficult economic climate. Persistent high unemployment, weak housing prices, low wage growth and limited access to credit are all combining to pressure consumer sentiment and limit discretionary spending. Since our call last quarter, a few macro-indicators that changed for the positive. And as a result we continue to believe that the economy and the early indications of a recovery remain fragile.

Turning now to our top level metrics during Q2, we said second quarter records for visits, user registrations, image shares, customers, orders, average order value and net revenues with all metrics showing a clear improvement from the activity we saw in Q2 of 2009 while these overall metrics Q2 were quite stable.

We did see some moderation in activity during late June and July that we believe is consistent with broader retail and e-commerce trends. During Q2, we had 1.1 million transacting customers, we generated 1.8 million orders with an average order value of $25.56. This solid transaction activity translated into 18% year-over-year growth in customers, 9% growth in order volumes and 11% growth in average order value. The AOV improvement continues to be driven primarily by shifts in product mix from print to higher value personalized products.

Let’s now move to our reported results starting with net revenues. Net revenues for the quarter totaled $46.8 million, reflecting 20% year-over-year growth and 25% growth excluding referral fees. The allocation of net revenues between new and existing customers was 25% and 74% respectively, with continued strong year-over-year growth in new customers.

In terms of product mix, personalized products and services represented 68% of total net revenues and total prints represented 31%. Net revenues from 4x6 prints contributed 16% of total net revenues, down from 22% in the prior year. And our commercial print initiative added $760,000.

In terms of net revenue growth rates, personalized products and services increased 34% year-over-year and 42% excluding referral fees. This solid revenue performance was led by continued strong, double digit growth in Photo Books, as well as significant contribution from our cards and stationery collection.

Total print revenues declined 2% from the prior year, though a notable improvement from the 7% decline we saw in Q2 of last year. This modest revenue decline was primarily attributed to lower ASPs associated with various 4x6 print marketing campaigns.

Moving to cost of net revenues and gross margins we reported a gross margin of 50% during Q2 exceeding our guidance and well ahead of the 48% margin reported in the prior year. The strong margin performance resulted from several factors including improved product mix labor efficiency and lower material costs partially offset by promotional discounts and lower margin commercial print revenues.

Technology and development costs totaled $12.5 million for the quarter an increase of approximately 14% over the prior year. Excluding stock base compensation and depreciation our tech and dev spending increased approximately 1.7 million. As we discussed earlier this year, the substantial majority of this amount is attributed to the engineering and other product development investment we are making to improve the depth and quality of our product and services offerings.

Continuing down the income statement sales and marketing costs totaled $11.3 million in the quarter representing 24% of net revenues verses 23% in the prior year. Excluding stock base compensation the $2.2 million year-over-year cost increase is associated primarily with expanded online media and direct response and partner marketing campaigns.

During Q2, our total sales and marketing expense per transacting customer excluding stock base compensation increased about 8% from the prior year and remained below $10. General and administrative expense for the quarter totaled $9.6 million or 21% of net revenue consistent with Q2 of last year. Excluding stock based compensation and credit card processing fees which vary with revenue volumes G&A expenses approximated 13% of net revenues in the quarter, a 2 percentage point improvement from Q2 2009.

Adjusted EBITDA for the quarter totaled $1.2 million exceeding our guidance and a notable improvement from last year. This continued growth in EBITDA profitability resulted primarily 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 38.7% reflecting Q2 discreet items as well as our full year estimated effective tax rate.

On the GAAP basis, our net loss for the quarter totaled $5.9 million or $0.22 per share based on 27 million outstanding share. Now I'd like to provide some additional insight on our capital expenditures and liquidity. Capital expenditures during the quarter totaled $5.3 million including $3.6 million for technology equipment in software, $436,000 for manufacturing equipment and building improvements and $1.3 million in capitalized software development cost.

Cash and investments at quarter end totaled $159 million, and as expected our remaining portfolio of auction rate securities once reaching their par value on July 1, 2010.

With the increased liquidity resulting from the auction rate redemption, we did not renew the $20 million line of credit that expired on June 23. To complete my discussion today, I'd now like to summarize our revised outlook for Q3 and the full year 2010 together with some insight on our underlying assumptions. Consistent with our historical trends across each month in Q2 and continuing through this week, we have seen some moderation in our site traffic and order volume.

While Q3 quarter to date growth rates are currently outperforming the lower levels from 2009, we expect that the current economic challenges will continue to impact our business throughout 2010. I would also like to reemphasize that our growth rates in 2009 progressed from 5% in Q1 to 10% in Q2, 13% in Q3 and 22% in Q4.

As a result of this increase in prior year comparisons and the loss of $4 million in current year referral fee revenues, we expect to see continued healthy growth in our core business for a more modest improvement in our annual revenue growth rates. In terms of the components of net revenues, we continue to expect some improvement in non-holiday growth rates with more elevated increases around the traditional holiday and gift giving period. We expect a consistent mix of revenues between new and existing customers with modest growth in average order value. And finally we expect a continued shift of revenues from 4x6 and other print categories to our award winning line of personalized products and services.

With respect to our commercial print initiative, we are progressing on our plan to expand our customer base and the number and variety of commercial print transaction. Consistent with our earlier guidance we continue to believe that 2010 commercial print revenues will likely range from $5 to $7 million and have maintained this range in today’s financial guidance.

In terms of our cost structure for 2010, we remain firmly committed to our strategy of carefully balancing investments for growth with our philosophy of increased profitability and free cash flows. With the recent trends of improving business performance, we are on plan with a number of new technology initiatives that we believe will both increase the rate of innovation and our products and services as well as significantly improve our long term operating efficiency.

These investments are focused primarily on our core technology platform and user experience. But also extend to our CRM and other marketing and analytical systems. With these comment as context contact I will now summarize our updated guidance for Q3 and full year 2010 starting with Q3.

We expect net revenues to range from $45.5 million to $47.5 million with year-over-year growth rates of up to 17%. Excluding referral fees, this guidance reflects net revenue growth rate of up to 21%. We expect our GAAP gross margin to range from 47% to 49% of net revenues and our GAAP operating loss to range from $12 million to $11 million.

Excluding referral fees, this guidance reflects a year-over-year gross margin improvement of up to 4 percentage points. We expect that our adjusted EBITDA will range between a loss of $2 million and loss of $1 million. And that our GAAP effective tax rate will range between 33% and 38%.

And finally we expect the GAAP net loss per share to range from $0.30 to $0.26 based on approximately $27.3 million weighted average common shares. Turning now to the full year 2010, we now estimate that net revenues will total between $277 million and $287 million with year-over-year growth rates ranging from 12% to 16%.

Excluding referral fees this guidance reflects year-over-year revenue increases ranging from 14% to 19% versus a 16% growth rate in 2009. We expect the full year GAAP gross margin to range from 54% to 56% of net revenue, a notable increase from our prior guidance of 53% to 55%.

Excluding referral fees, this guidance represents a gross margin improvement of up to 2 percentage points over 2009.

We expect that our GAAP operating income will range from approximately $10 million to $14 million and then a full year 2010 EBIDTA margin will range from 19% to 20% of net revenue. Excluding referral fees this revised guidance reflects a year-over-year improvement of up to 1 percentage point and our annual EBIDTA profitability. The full year GAAP effective tax rate is expected to range from 33% to 38%. Also, as a reminder, we expect to accrue taxes payable for federal purposes during 2010 and we'll begin remitting cash taxes in early 2011.

We continue to maintain net operating loss carry forwards for California State taxes, and do not expect to generate any significant California cash liabilities during 2010. We now expect that full year GAAP net income per share will range from $0.23 to $0.32 per share based on $28.9 million weighted average diluted shares. And consistent with our prior guidance we expect that full year 2010 capital expenditures will range from 7% to 9% of net revenue.

So in summary, in light of the continued tough economic environment, we believe that our updated Q3 and full year 2010 net revenue and profitability guidance reflects our most recent operating performance and is appropriately thoughtful given current market conditions. So with that I thank you for your time today and look forward to speaking with many of you in the days and weeks ahead. We’ll now open the call for your questions.

Question-and-Answer Session

Operator

(Operator Instructions). Our first question comes from (Lynn Bracken) from Bracken Capital. Your question please.

Unidentified Analyst

What about the metrics weight June is it July so I just wanted to just cash out what exactly you saw in that time period and this is sort of (inaudible) you raise your revenue guidance for the quarter, I just wanted to ask the question again just to be clear.

Mark Rubash

This is Mark, what we saw was a pretty steady metric I will call them top of funnel metric so for us those start with visits to the sites registrations of new users, uploads of photos and sharing of photos and so on and as we got into late June and early part of July we saw some moderation in the growth rates. That seemed to coincide with the broader macro trends of the drop in consumer confidence and some of the retail numbers came in soft during that period I think part of it is also is contributed just to seasonality as people get out on the summer vacations they are less likely to be indoors I think.

Unidentified Analyst

Is it last year at the same time or was it more this time.

Mark Rubash

There's always some seasonal moderation going from Q2 into Q3. I think its a little bit greater than what we might contribute to seasonal, don’t know ifs its a trend, don't know if its something a broader macro trend that's developing, I just pointed out because I think its useful as you consider our guidance.

Unidentified Analyst

Okay. I just have a quick follow up, the gross margin guidance it started the year at 51 actual and then I think by the third quarter we'll be in the range of 47 to 49. Can you just describe what is causing the decline there, is it product mix or is there something out there that we should be aware of.

Mark Rubash

No, primarily its product mix. If you go back to last three years, we've had about a 1 percentage point downward change from Q2 to Q3. Q3 tends to be a little more print centric in terms of product mix versus photo books and other personalized products. So, it's primarily attributable to that. The other thing as we get into the later part of Q3, we start our kind of on boarding process for temporary work and training as we get prepared for Q4. So, nothing structural changes other than really some of the seasonal things we do as well as the mixed shift that occurs and each quarter is a little bit different in terms of the mix, just based on the holiday content and the nature of the occasions that occur in the quarter.

Operator

Thank you. Our next question comes from the line of Imran Khan from JPMorgan. Your question please.

Imran Khan - JPMorgan

Hi, thank you very much for taking my questions. Two question, can you talk about the impact you are seeing from Simple Path and other new Photo Books product plus partnership on frequency of purchase. Are you seeing customer purchasing Photo Books more often or still typical of six special occasion.

And secondly going back to the first question, you pointed out that a greater seasonality but then you are raising guidance. So just trying to get a sense, how much, is your confidence on your guidance is lower than the previous few quarters or you have the similar kind of confidence level on your third quarter guidance. Thank you.

Jeff Housenbold

Great, Imran I'll take the first one and hand over to second one on guidance to Mark. Simple Path is performing well for us. I think its doing what it was intended to do which is to lower the barriers to entry to trial of Photo Books as we went out and talked to customers we heard there was an awareness on GAAP Photo Books existed that there was a time concern and that an ease of use concern and price to get people into the category and so Simple Path addresses a number of those at the cost through a smaller format soft cover. You can make a Photo Book in less than five minutes and we make it for you and so what we are finding is that Simple Path is helping to bring new customers into the Photo Book category and we are starting to see it early but we are starting to see traditional custom fab, folks who have reserves making photo books for those special occasions starting to embrace Simple Path for more of the everyday memories. So early days on Simple Path very pleased with how its performing for us and it is another example of our further differentiation in the marketplace.

Mark Rubash

So on the guidance question in terms of confidence I would say it’s pretty consistent with where we have been and where we were in Q2. If you exclude referral fees from all the calculations, Q1 and Q2, we had a growth rate of about 25% and at the high end of our guidance for Q3 on a similar calculation or about 21% but we also have a 3% more difficult comp in Q3.

So I would say the health of the business is pretty stable across all of the quarters. I think the approach to guidance and the level of conservatism is pretty consistent. The challenge and the reason I provide those metrics is just the sensitivity of our business to Q4 and I don’t know what to make up at this point other than we are seeing a modest reduction in the traffic and order volumes through the early part of Q3. But I don’t know that if it’s a trend and it is certainly not something that we are overly concerned about at this point.

Operator

Thank you. Our next question comes from the line of Youssef Squali from Jefferies & Co. Your question please.

Sandeep Swadia - Jefferies & Co.

Hi good afternoon this is Sandeep Swadia sitting in for Youssef. Just a couple of questions. I think just the same sorry for going back to the first question but given the moderation in June and July historically have you seen any correlation between that type of a dip in the fourth quarter activity because your top line guidance for the year says you (inaudible) rightly so again what kind of macro environment and customer activity assumptions are they are taking in and I have a follow-up.

Mark Rubash

Yeah, I think the bigger things to think about for us, the highest correlation is more about recently purchased transaction throughout Q1 through Q3. So the number of new customers almost regardless of what categories or what products, the purchase is probably the biggest and best indicator.

We have seen as you will recall for 2008-2009, we are also highly correlated with consumer sentiment kind of at the macro level. But I think clearly in our core products of the Photo Books and cards and stationery we continue to see acceleration in those growth rates including Q2.

We expect that trend to continue and then the other thing to think about Q3 is there’s no holiday from a gift giving standpoint in Q3. It also tends to be a little bit more back end, loaded towards the back of the quarter as families in particular come back off of their summer vacation and get ready for school. They tend to be more photo rich. So I don’t think there’s anything in the traffic patterns that we’ve seen in the recent weeks that give concern about Q4, but it is something, one of the metrics that we pay attention to.

Sandeep Swadia - Jefferies & Co.

Okay that's helpful. You’ve talked about PPS so and I hope I'm interpreting the numbers right, but any particular reason for the deceleration in the growth? Remember last quarter it was 43%, its 34% in the second quarter, is the slump in June partly the culprit, or is there anything else going on?

Mark Rubash

No I think one thing in Q1 you have a pretty large calendar business that kicks in, that’s a part of PPS and Q1 of this year was going over a pretty low comp from last year. But if you look at the key revenue contributors, the Photo Book and cards and stationery, both of those categories are accelerating year-on-year. The other delta in terms of PPS, keep in mind that we have no referral fee revenue in PPS after Q1 of this year.

Sandeep Swadia - Jefferies & Co.

That right. But the trend you saw in June-July was across all the product lines, so it wasn’t specific to print or PPS or anything that you could draw conclusion over?

Mark Rubash

Yeah, and I wouldn’t say that it’s impacting our revenue with some of these top level metrics, not necessarily revenue metric. I feel very good about, particularly the key products.

Operator

Our next question comes from the line of Mitch Bartlett from Craig Hallum. Your question please.

Mitch Bartlett - Craig Hallum

Yes, I’d like to just take up where you left off. So you are saying that Photo Books and cards and the stationary, those accelerated Q1 to Q2 as far as the growth rate. I mean I think you said in your prepared text excluding the referral fees PPS grew what 41% so its not much, 42% percent, so, and the two main categories are accelerating. So something’s slowing down probably what calendars are non-seasonal now or something like that.

Mark Rubash

Right, calendars are non-seasonal. You have very little contribution from calendars and then prints were down in total about 2% and 4x6 a little bit slower than that because of the amount of promotions we were doing with prints right now.

Mitch Bartlett - Craig Hallum

Okay, very strong. So I am taken by how many customers you are adding obviously, very strong on those metrics and going to the guidance question and everything else but is the life time value of a customer that you’re acquiring today is that remarkably different in anyway up or down from a year or two ago. I mean can you see to that?

Jeff Housenbold

Sure, this is Jeff, as we talked about over the last year or so we are starting to see our new customers engage into Shutterfly’s products PPS category more so than in print as they had done historically, and the average order size of the Photo Book or cards and stationery tends to be higher than a print purchase so what we are seeing is increase in ALV driven by that mixed shift and as we continue you can see the percentage of revenue coming from existing customers is high. We are continuing to grow the life time value of our customers and a large part of that is the mixed shift from prints to PPS.

Mitch Bartlett - Craig Hallum

And that mixed shift, it has been in place for quite some time, so our recent customers performing the way, excluding the print just on a pure PPS, are they performing the same way as they did a year ago or are they accelerating?

Jeff Housenbold

It's actually accelerating. We talked about this last quarter that new customers average order size there was slightly higher than existing customers and we saw that trend continue and actually grow, it was about 5% higher than existing customers for Q2. So, new customers are coming in, they are engaging with Photo Books, cards and stationery they are more comfortable with the platform and the knowledge of the product and they are behaving more like existing customers and I think that trend bodes well for us going forward.

Mitch Bartlett - Craig Hallum

For the fourth quarter, I'm sure. So, and gross profit margin, I just wanted to focus on that. It seems like in periods path there is a little bit of a trade off between sales and marketing and gross profit margin if you put the peddle down on promotions. Was this last of the promotional periods than say recent periods?

Jeff Housenbold

I would characterize it as pretty consistent on our promotional approach. I think we are gaining additional efficiencies in our manufacturing facility in the MLS line and so we have been combining as you said we sometimes trade off card sales and marketing dollars in terms of advertising to use targeted promotions through our one-to-one personalized marketing CRM capabilities to drive, trial, or repeat purchase but the gross margin improvements that we are getting in manufacturing are allowing us to continue to invest that across the board and then to the previous question about Q3 versus Q2 gross margins, if you go back to ’07 and ‘08 Q3 was about 300 bits lower in gross margin in Q2 and last year it was a 100 bits lower. So our guidance is reflective of the fact that Q3 tends to be slightly lower from of mix of products sold.

Mitch Bartlett - Craig Hallum

Just one last question, I missed the first part of the presentation but have you talked about a marketing program to reach out to the Facebook folks?

Jeff Housenbold

We didn't talk specifically about that in the prepared remarks. Outside we continue to develop more and more integration into Facebook. We have done that through our share sites and most recently in our Simple Path Photo Book creation process. You can now go in and grab your pictures from Facebook and your friend’s pictures and be able to make a Photo Book in less than five minutes.

We are also doing some modest advertising on Facebook more in the experimental stage than a full campaign and then of course we have our Facebook fan page which is doing quite well and drives viral awareness and trialed our products

Operator

Our next question comes from the line of Michael Olson from Piper Jaffray.

Michael Olson - Piper Jaffray

Just wondering how you guys are thinking about video and mixed media offerings, like Animoto and things of that nature that add music to photo slide shows or automated video editing. I know you got your partnership with Motion Box but can you talk about how important the category of video or other multimedia projects will be for Shutterfly going forward. I have realized that the market is far from saturated in Photo Books but will those other categories potentially be an area of increased important longer term?

Mark Rubash

On video its still early days as it relates to consumer generated video and business models that produce profits around that. So there are a number of companies as you mentioned Animoto and there's two dozen others that offer what I will call a multimedia mash up where they combine photo, video, music and audio and it enhances the overall sharing and viewing experience.

But no one is making money from those services today. So we are looking at it. We obviously have a playing video, we were the first to market. We upgraded the service to (inaudible) allowed as to integrate it deeper into the Shutterfly flow. So its more of a seamless experience for the customers. I think those are still what I will call in the early experimental stages. We are getting good adoption but the monetization isn’t there and it isn’t there for us or Picasa or Flicker or Microsoft or Apple or any of the other folks and so its still to be proven if customers are willing to pay for those what I will call enhanced sharing and viewing experiences.

Operator

Thank you. Our next question from the line of Colin Sebastian from Lazard Capital Markets. Your question please.

Greg Lazard - Lazard

Yeah hi, this is Gregory Lazard calling in for Colin. And yeah coming back to the marco topic, I was curious do you guys, have you just seen some of the drop in the conversion rates of your customers as a macro environment tends to decrease, I know you mentioned that, the recent purchases was (inaudible) productive but I was wondering if that was another thing that we saw in finance.

Mark Rubash

No, in fact the conversion rate from visit to registration that has been a very consistent, very healthy metric for Shutterfly and continues to be, similar for activations from a registered user to a transacting customer. That has actually been an improving trend over the last several quarters.

So what we've been seeing really is moderation and I won’t call it a significant slowdown, I’d call it a moderation in traffic. And I think if you go across e-commerce a lot companies are probably testing the same type of moderation in late June and into July.

So to be determined whether those traffic patterns are seasonal and people are just out because the weather is warm and its vacation season or sentiment and some of the other economic concerns are building in a new mail kind of thought process for the consumer. But, in terms of converting those customers and getting them into our creation paths and products, those are very stable metrics for us.

Unidentified Company Speaker

Yes and just to add to that as the marketing team continues to refine our approach, we’re tracking a higher quality customer leading to higher conversion rates. And those customers continue to be viral for us keeping our overall acquisition costs quite reasonable relative to the first quarter value and the first year value of the customers.

Greg Lazard - Lazard

And one other question, I mean your customer metrics they are doing really well and you guys are faring well in a tough environment, but do you sometimes wonder why the overall customer base is as small as it is when you just come through the overall potential market opportunity in the United States and whether there's just some other opportunity to do something different or more experimental on the marketing front? Because you think that most people in the United States have or most families have historically had Photo Book or photo album. And you guys wonder sometimes if its you’re getting this nice growth, but its seems to be incremental over time and whether it maybe way to I know it will be great, as you are trying to increase but I am just curious whether you guys are sometimes a little surprised by that.

Mark Rubash

Yeah, I think what gets us really excited about the future is that we are playing in multiple multi-billion dollar markets that are still at their earliest days of transforming from an analogue paradigm to a digital paradigm. So its still only about 15% of US households have made something in the personalized products and services category and the greatest barrier to date is just the awareness that you can do this.

People’s paradigm is still related to the old print world where they walk into retail with a roll of film or they are printing at home on their home printer. As we continue to expand through our bio marketing through our share sites, through our Photo Book processes like Simple Path reducing the barriers or our gallery or our home parties or the other various integrated marketing levers that we are pulling, we continue to increase awareness and that's driving higher conversion rates, higher average order value and higher revenue quarter by quarter.

But we haven't hit that inflection point yet as an industry where awareness is at that point where you are going to see that hockey stick part of the adoption curve and that's what makes the future so exciting for us as we continue to chip away at the barriers as we continue to increase awareness. We think that the Photo Book market can become very large relative to its current size.

Operator

Thank you. Our next question comes from the line of James Cakmak from Sidoti & Company. Your question please

James Cakmak – Sidoti & Company

As you look forward into the fourth quarter its been two months late, can you talk about what you are doing to prepare for that any campaign or a potential product launch as we gear up for due and secondly with the Facebook integration. How much greater are your expectations there than with your other more traditional partnerships, and if you can talk about the economics of that relationship?

Jeff Housenbold

Sure James, this is Jeff. We won't give out specific product launches for Q3 on today's call largely for competitive reasons but if you look back historically what we have done in Q3 given that we typically freeze new product releases in late September, early October is we try to make sure that our assortment of products, our designs, the user experience, our marketing acquisition channels, all those are optimized for Q4 on the front end and then obviously our manufacturing teams in turn are making sure enough raw material that labor is staffed up appropriately, that we have customer service, all that ramped up and trained ready for the seasonally strong fourth quarter. And so we are going through that typical Q3 ramp up that we've done now for 10 years.

So, we are excited about what we have launched so far this year, what we announced on today's call that we did in Q2. We have a few more things coming up in Q3 and that will make you guys aware those as they launch to the consumer.

As it relates to Facebook, I think this is another one of those things that gets us excited about the future is that the trend of people generating more and more user generated content, the ability and a frictionless way to share that content and then the human desire to turn those pictures and moments into stories and preserve and share those beyond just simply looking at a photo on a screen or simply a 4x6 print bodes really well for our award winning line up of products given that we have the best user experience, the strong brand and the highest quality from our vertical integration. So, I think we are keyed up quite nicely for the remainder of the year, I think our increased guidance today reflects that. I think the trends that we have been experiencing over the last four quarters reflects that, and I think we will continue to drive the innovation that has led us to be successful so far.

James Cakmak – Sidoti & Company

And could you comment on the economics of that relationship?

Mark Rubash

So the current relationship as we plug into Facebook’s APIs and then connect feed and we are able to draw upon that and so there is no economic going back and forward between us to Facebook. We do advertise on Facebook from time to time and we evaluate that like we do any other customer acquisition channel which is we look at the ROI of that spend and so we put that into the overall mix but Facebook is trying to create a open platform that allows people to create applications that enhance the overall social networking experience and they see us in doing that in a favorable light.

James Cakmak – Sidoti & Company

And with respect to share sites, that is obviously an important component of the growth, can you remind us how many share sites you have now versus where we were last year?

Mark Rubash

Yeah at the end of the quarter we had a little over 2.1 million share sites created. I don’t have the numbers for last year in front of us but we have been out with that for about two years now and we continue to grow primarily focused on family, on baby, youth sports and classrooms and travel would be the four largest categories of usage and it's driving both stickiness, frequency of consideration, awareness and its driving trial and repeat behavior and it is a meaningful contributor to our new customer growth. So we are very delighted in our share sites and again another example of a service that differentiates us in the marketplace.

Operator

(Operator Instructions) Our next question comes from Scott Devitt from Morgan Stanley. Your question please.

Scott Devitt - Morgan Stanley

Thanks, hey, just one question one just the social aspect of the business and the way that you position the company relative to your two direct comps in terms of the product differentiation, the share sites, the iPhone app linking to Facebook, etc. and you mentioned, friction points in terms of trying to reduce friction driving accelerating growth.

I was just wondering if you can talk through when you think those investments start to actually cause an inflection plan in the businesses at which you actually see a change in rate of transition in terms of consumer. How that's in terms of where they are actually off to for their sites and purchase their products recognizing that you are already going faster than the industry it seems like there's a significant opportunity ahead to actually seen a meaningful inflection point in the business. I don't know if its photo quality on these third party sites or otherwise.

Mark Rubash

I think we are not there yet, but our share sites are having a meaningful impact on our business today. Simple Path is having a meaningful impact today. Our integrated marketing, our innovation, the fact that our designs resonate with our customers, the ease of use of the website, the quality of the physical products.

All of that has allowed us to grow faster than the marketplace and maintain a price umbrella and the highest profitability margins in the industry. And so when I look at the adoption of things like smartphones or tablets or social media I just think those things are going to continue to benefit us down the road and there will be plenty of ways that people share photos. The largest way people still share photos by the way is through email. And then after email it’s Facebook, and then its sites like Shutterfly and our share sites. And so people are still in an old paradigm of prints and they are still in an old paradigm of email usage that we believe over the next few years that, that will shift. And when that happens we should see accelerated growth rates and adoption rates. And I think all the things I mean testing these new applications, new devices, new integrations are going to make us smarter and ahead of the curve when those paradigms do start to shift.

Scott Devitt - Morgan Stanley

And I apologize if I missed this but could on multiples calls did you give the number and is that spilling over to the iPhone and when do expect to launch the iPad specific app?

Mark Rubash

We didn’t give the updated iPhone numbers, I don’t have those in front of me. I think we are very pleased with the iPhone app, it’s largely a sharing and viewing application to date. And it’s a great way when you run into friends on an airplane to be able to always have access to your Shutterfly photos with you. It wasn’t created to drive large commerce in version one. So it's not having a meaningful impact on revenue today, but it is an extension of us providing a value added service to our customers which drives thick and loyalty and higher lifetime values.

As it relates specifically to the iPad we haven’t given a timeframe for a specific iPad app to date, but its something that we're considering.

Operator

Our next question comes from the line of, a follow-up question from Mitch Bartlett from Craig Hallum. Your question please.

Mitch Bartlett - Craig Hallum

Just a follow up question on the share sites. I can almost anticipate you won’t answer the question but I think it’s really important. In the Group share sites category you talked about the four categories, family, youth, classroom, travel, in the group slide. You haven’t updated that if I still remember share sites in quite a while, will you do that?

Mark Rubash

You mean breaking out groups versus individual sides.

Mitch Bartlett - Craig Hallum

Yeah, that would be great, yeah.

Mark Rubash

No, we haven’t done that and we’ll go back and consider that as we prepare for next quarter’s call. Let me talk directionally about it. We continue to see very nice adoption between individuals and families and in Groups centered largely around huge sports, classrooms so we also see adoption from online groups, charities, church and other community groups and so we are very pleased by that adoption and the strength of the group is that typically a group has 20, 30, 50 members and so they are getting exposed to our brand, our products and that drags conversion and we are seeing that happen and that's having an impact on our new customer acquisition numbers and hence revenue.

We are working on a number of business development relationships in the group arena and you can expect to see some announcement in the third quarter and we believe those types of business relationship will allow us to accelerate the Group share site creation numbers.

Operator

Thank you. This does concludes the question-and-answer session of today's program. I’d like to the program back to management for any further remarks.

Jeff Housenbold

I want to thank everyone for joining us on the Q2 earnings call as Mark and I said in our prepared remarks very good strength in top line for the second quarter. We delivered the top line revenue with better than expected margins which we're pleased at. If you look at the growth of personalized products and services. Without referral fees, those grew 42% which is a very healthy growth metrics in what is still a challenging economy and Mark's comments about a little moderation in the top of the metrics in June and July, we are incorporated into our Q3 and full year guidance which we did take up from our previous guidance and so we remain very optimistic about the business for 2010 and we believe that our market leading position will continue to drive long term shareholder value. So, with that I want to thank you again and we look forward to seeing you guys out on the roof.

Operator

Thank you, ladies and gentlemen for your participation in today's conference. This does conclude the program. You may now disconnect. Good day.

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Source: Shutterfly, Inc. Q2 2010 Earnings Call Transcript
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