Shutterfly, Inc. (SLFY) Q2 2014 Earnings Conference Call July 30, 2014 5:00 PM ET
Michael Look – VP, IR
Jeff Housenbold – President and CEO
Brian Regan – SVP and CFO
Heath Terry – Goldman Sachs
Youssef Squali – Cantor Fitzgerald
Colin Sebastian – Robert Baird
Paul Bieber – BofA Merrill Lynch
Rohit Kulkarni – RBC Capital Markets
Kerry Rice – Needham & Company
Mitchell Bartlett – Craig-Hallum Capital
Trisha Dill – Wells Fargo Securities
Shawn C. Milne – Janney Montgomery
Victor Anthony – Topeka Capital Markets
Chris Merwin – Barclays Capital
Brian Fitzgerald – Jefferies & Co.
Kevin Kopelman – Cowen and Company
Good day, ladies and gentlemen, and welcome to the Shutterfly Second Quarter 2014 Financial Results Call. [Operator Instructions] I would now like to turn the call over to your host, Mr. Michael Look, Vice President of Investor Relations. Please go ahead.
Thank you, operator. Good afternoon, everyone and welcome to Shutterfly's second quarter fiscal 2014 financial results conference call. With us today are Jeff Housenbold, Chief Executive Officer of Shutterfly; and Brian Regan, Chief Financial Officer. By now, you should have received a copy of our earnings press release, which crossed the wire approximately 1 hour ago. If you need a copy of the press release, you can go to shutterfly.com under the Investor Relations link to find an electronic copy. We've also released the presentation that we will use as we go through this call. Call participants are advised that the audio of this conference call is being recorded for playback purposes and that a recording of this call will be made available on our website within a few hours. You can access these recordings through the Investor Relations section of our website at shutterfly.com.
Before we begin, I'd like to note that our discussion today will include forward-looking statements within the meaning of the Securities Act of 1933 and the Securities Exchange Act of 1934. These forward-looking statements include statements about our business outlook and strategy and the assumptions underlying those statements, and statements about historical results that may suggest trends for our business. For more information regarding the risks and uncertainties that could cause actual results to differ materially from those expressed or implied in these forward-looking statements, as well as risks relating to our business in general, we refer you to the Risk Factors section of our most recent Form 10-K and Form 10-Q and other filings with the SEC.
I would also like to note that any forward-looking statements made on this call reflect information and analyses as of today, and we assume no obligation to update this information. This presentation contains certain financial performance measures that are different from the 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 fiscal 2014 financial results press release, which is posted on the Investor Relations section of our website at shutterfly.com.
Now I'd like to turn the call over to Shutterfly's CEO, Jeff Housenbold. Jeff?
Thanks, Mike. Good afternoon everyone and welcome to our second quarter 2014 earnings call. I will start with an overview of our Q2 results and will then turn the call over to Brian for a detailed review of our financial results as well as our financial guidance for the second half of 2014.
Q2 was another quarter of solid execution and continued momentum, representing Shutterfly's 54th consecutive quarter of double-digit net revenue growth. During the quarter we drove profitable revenue growth in our consumer and enterprise businesses, resulting in revenues of $159.1 million, an increase of $25.7 million or 19% growth from the prior year. Notably Shutterfly brand revenues increased 21% over the prior year driven by growth in cards, stationery and photo gifts during the Easter, Mother's Day, Father's Day and graduation gift giving periods.
Adjusted EBITDA was $11.7 million representing a $5.4 million or 86% increase over the prior year. Our better-than-expected adjusted EBITDA margin performance was largely driven by operational efficiencies and timing shifts of expenditures and marketing and hiring.
During the quarter we made significant progress in key initiatives including the opening of our Midwest production facility in Minnesota. The relocation of our data center to Nevada and the final updates to our ThisLife’s beta experience. We also continue to leverage our market leadership, healthy balance sheet and integrated data-driven pricing and promotional strategies to increase brand awareness and drive healthy customer behaviour.
Let me provide some more details into the strategic initiatives and our continued innovation starting with our core businesses. We continue to expand our product and services assortment and during the second quarter the Shutterfly brand introduced new home decor collection offerings like our designer wall bundles that allow customers to easily create, order and hang a wall arrangement. The collection was launched at a recent media event and received accolades from key tastemakers like Martha Stewart.
We also launched new metal wall art, pillows, glass prints, new styles of iPad cases, personalized lunch bags and smartphone battery cases during the quarter. In addition, in the photo book category, Shutterfly introduced new enhancements including new styles, matte, satin and silk covers and memorabilia pockets providing even more ways for our customers to personalize and cherish their memories.
At our Tiny Prints brand we launched new gifts and décor items in addition to a new graduation stationery collection with teen celebrity Victoria Justice and a personalized stationery collection with fashion designer Charlotte Ronson. We also announced the cause marketing relationship with Baby to Baby, a nonprofit that supports low-income babies and families with the Mother's Day event that included celebrity moms Molly Sims, Rachel Zoe and Nicole Richie.
The Wedding Paper Divas brand introduce foil stamps new envelope packaging, embellishments and enclosures, and gift tags to enhance brides ability to put their personal touch on their wedding stationery. We also launched a partnership with Pottery Barn Wedding Registry to introduce newly engaged couples to the Wedding Paper Divas brand early in their wedding planning process.
On the mobile front, we continued to improve our cross brand offerings and launched new product and style options for the Shutterfly photostory mobile app and made improvements to the treat and Shutterfly shopping experiences. These and our cumulative enhancements to the mobile are making an impact. During Q2 mobile drove nearly 11% of revenues on the Shutterfly brand, up from 5% in the same period a year ago.
ThisLife, our new memory management application, makes it easy to seamlessly gather and organize photos and videos from virtually anywhere into one safe and secure place, so customers can enjoy, share and do more with their memories. This service came out of beta earlier this month with new enhancements including improved organization and management tools, a simplified upload process, more sharing options, platform improvements, mobile enhancements and new marketing site.
Next week our marketing campaign will begin with touch points on-site, inbox, online via social, on radio, in movie theaters through houseparties and with co-marketing partners. As planned, we will dial down marketing activities during the Q4 holiday season and scale activities up again in Q1 2015 based upon our marketing test results.
We continued to make meaningful progress with our enterprise business and during the quarter made investments in preparation for large program executions in the second half of 2014. In particular our managed care practice and retail verticals continue to show major growth opportunities as clients leverage our content management and personalized focused output platforms to create dynamic marketing materials. Based on our sales pipeline we believe the second half of 2014 will show marked acceleration in year-over-year revenue growth rates. T
The team continues to make progress on our infrastructure and operational initiatives. Our Midwest production facility opened earlier this month on schedule and within budget. The location adds a level of redundancy in our manufacturing network and supply chain, further supports our scale needs and fulfillment strategies such as next day delivery and ultimately increases customer satisfaction levels. The team is on track for scaling our workforce and manufacturing footprint in preparation for the holiday season.
The relocation of our new storage and co-location center to Nevada is also on track for completion this month and will be fully operational by the Q4 holiday season. This facility will optimize our long-term cost structure and improve our service capabilities.
In summary we continued to execute against our strategic plan in the second quarter with good progress in key initiatives in our core consumer and enterprise businesses, in addition to important operational and infrastructure improvements. The teams delivered solid revenue growth and EBITDA margins while continuing to make meaningful investments for Q4 and beyond. I am confident that we have the right strategy in place to grow our family of lifestyle brands and continue to disrupt the memory and personalized products industries.
With that I will now turn the call over to Brian to review our financial results and outlook in greater detail. Brian?
Thanks Jeff and good afternoon everyone. I'll begin my comments today with some observations about our second quarter performance, key metrics and operating results. I will then conclude with an overview of our Q3 financial guidance and an update to our full-year outlook for 2014 before opening the call up for your questions.
Earlier today we posted second-quarter results that exceeded our guidance for net revenues, adjusted EBITDA, net loss and EPS. Our solid Q2 performance as Jeff indicated earlier was once again driven by strong growth in our consumer business combined with lower-than-expected costs in the quarter being shifted to later this year.
Taking a detailed look at our results, net revenue for the second quarter totaled 159.1% representing a 19% increase over the prior year and above the $158 million high end of our guidance range. Consumer revenue was $150 million reflecting 20% year over year growth largely driven by strong cards and stationary, photo gifts and home décor sales at our core Shutterfly brand during springs, Easter, Mother’s Day, Father’s Day and graduation occasions.
Net revenue from our enterprise business grew 5% year-over-year to $9 million. We remain excited about the potential for the enterprise business as it utilizes the available capacity of our market-leading digital printing capabilities and provides incremental revenue and free cash flow. As Jeff indicated we believe our promising enterprise sales pipeline will produce significant acceleration in year-over-year revenue growth rates in the second half of 2014.
Throughout the second quarter we remained focused on profitable customer acquisitions and continue to leverage our integrated marketing platform and data driven pricing and promotional programs to increase brand awareness and drive healthy customer behaviour.
During Q2 total unique transacting customers and orders increased year-over-year 13% and 16% respectively. This resulted in a Q2 record of 2.6 million unique customers generating more than 4 million orders across all of our lifestyle brands. Average order value for the second quarter was a healthy $36.14, up 3% from the same period a year ago.
Moving to cost of revenues and gross margin. Gross margin in the second quarter was 47.6%, 137 basis points higher than our gross margin from the same period a year ago and above the 47% high-end of our guidance range. Q2's gross margin improvement was largely driven by operational efficiency gains in materials, labor and shipping costs due to our increased scale in insourcing partially offset by higher depreciation and equipment expenses related to the continued scaling of our Fort Mill facility and our new Shakopee Minnesota facility. We expect the start up costs for Shakopee to accelerate in Q3 as we ramp up operations and employees in advance of our Q4 seasonal peak.
Turning now to operating costs. Excluding stock-based compensation, OpEx totaled $88.7 million reflecting increased headcount costs, the increased cost structure from acquisitions and purchase accounting amortization. Looking more specifically at our operating expense component, technology and development costs totaled $32.1 million for the quarter or 20% of net revenues.
Excluding stock-based compensation and depreciation, our technology and development spending increased approximately $3.2 million or 16% from the prior year. Q2’s increase in technology and development spending was largely driven by higher depreciation expenses related to the relocation of our data center to Nevada as well as the incremental costs associated with the continuing strategic investments in technology and development headcount to support core products, mobile initiatives and ThisLife.
Sales and marketing expenses totaled $44.5 million in the quarter representing 28% of net revenue and roughly in line with Q2 of last year. Excluding stock-based compensation and amortization, sales and marketing expense increased 15.8% from the prior year to $34 million or 21% of net revenues, also roughly in line with Q2 of last year. This increase in sales and marketing expense was largely driven by investments in our integrated marketing campaigns and a modest increase in headcount.
General and administrative expense for the quarter totaled $25.9 million or 60% of net revenues. Excluding stock-based comp and credit card processing fees, G&A expenses represented 10% of quarterly net revenues, also in line with Q2 of last year.
Adjusted EBITDA for the quarter was $11.7 million. Our favorable Q2 EBITDA results reflect the combined effect of solid revenue growth, continued operational efficiencies and a shift in the timing of headcount and marketing investments into Q3.
The effective tax rate for the quarter was 11.3% and on a GAAP basis our net loss for the quarter totaled $27.1 million or a loss of $0.70 per share, favorable to our guidance of net loss per share of $0.75-$0.72 per share. The weighted-average shares used to calculate the net loss per share totaled 38.4 million shares and our Q2 share count reflects the repurchase of 282,000 shares during the quarter at an average price of $40.55 for a total of $11.4 million under our previously announced share repurchase program.
Capital expenditures during the quarter totaled $28.1 million including $11.1 million for technology equipment and software, $10 million for manufacturing and building improvements, $5.3 million in capitalized software development costs and $1.7 million for rental equipment.
Cash and short-term investments as of June 30 totaled $280 million reflecting our normal seasonal use of cash for working capital as well as the use of cash for our share repurchase program and investments made during the quarter. In addition to the cash and short-term investments our long-term investments totaled nearly $61 million at quarter end and we continue to have access to up to $200 million in currently available funds from our untapped revolving credit facility.
To conclude our prepared remarks today I'd like to summarize our outlook for the third quarter and fiscal year 2014. As Jeff stated at the start of this call, our business continues to exhibit momentum particularly at our flagship brand Shutterfly, our singular focus on consumers and steadfast commitment to innovation, design for our products and services, customer friendly policies and industry-leading quality continues to enable Shutterfly to differentiate ourselves from the competition and drive solid financial performance.
With these comments as context, we expect net revenues in the third quarter to range from $140.5 million to $143.5 million which reflects year-over-year growth of up to 17%. We expect our Q3 GAAP gross margin to range from 38 to 39% of net revenues. Our Q3 gross margin guidance reflects the combined effect of startup costs associated with the opening of our Shakopee Minnesota production facility, the continued scaling of our Fort Mill South Carolina operations, increased depreciation and amortization from acquisitions, a higher mix of enterprise revenue and continued strong sales growth of photo gifts which are typically outsourced.
Additionally we will incur a full quarter of duplicative data center costs in Q3 associated with our relocation to Nevada. As a result we estimate our Q2 GAAP operating loss to range from $51.6 million to $49.6 million. We estimate our adjusted EBITDA for Q3 will range between a loss of $9.5 million and a loss of $8 million and that our GAAP effective tax rate will range between 15.8% and 16.5%. We expect GAAP net loss per share to range from a loss of $1.22 to a loss of $1.18 based on approximately 38.4 million weighted average common shares.
Turning to the full-year, we now expect our 2014 net revenues to total between $905 million and $920 million continuing to reflect year-over-year growth of up to 17.4%. We expect the full-year GAAP gross margin to range from 51.5% to 52.5% of net revenues and non-GAAP gross margin to be 53.1% to 54.1%. We now expect that our GAAP operating results will range from a loss of approximately $2.5 million to GAAP operating income of $12.3 million, and our full-year 2014 adjusted EBITDA margin guidance remains unchanged from 17.8% to 19% of net revenues. The full-year GAAP effective tax rate is expected to range from 16.5% to 20%. We now expect full year GAAP net loss per share to range of $0.39-$0.09 per share based on 38.5 million weighted average common shares.
Excluding the effects of our convertible note offering we expect non-GAAP net loss per share to range from a loss of $0.11 to a non-GAAP net income per share of $0.20 per share and finally our 2014 capital expenditure range remains unchanged from 9.5% to 10.5% of net revenues.
So with that we will now open up the call for your questions.
(Operator Instructions) Our first question comes from Heath Terry with Goldman Sachs.
Heath Terry – Goldman Sachs
If you could give us a sense of -- as you have gotten deeper end of the operations of the new facilities, are you seeing the kind of efficiencies that you want, once you are fully sort of built out here what should we think about in terms of the excess capacity that’s going to -- for growth that’s going to exist in the system? And then finally I will ask it because I know somebody else will and obviously sort of topic of the day, but any thoughts strategically about Shutterfly as an independent company versus some of the alternatives that may present themselves to you?
This is Jeff. We just started bringing our new Shakopee Minnesota plant online in the last two weeks and it’s low volumes running through there. So obviously during the seasonally strong fourth quarter capacity utilization will rise markedly. Fort Mill is coming up on its first year and we've gotten great efficiencies, throughput, quality and customer satisfaction coming out of that plant and so we expect nothing different out of Shakopee in the next year when we open our new Arizona plant. The team does a great job of delivering on that.
When you look at our capacity footprint assuming that we still -- our Shakopee, Fort Mill and our soon to open next year Arizona plant fully with equipment which they're not, we only do that to meet demand curve. But if we did we should have enough capacity in our network to last us through about 2018, which means we would start to analyze and look at that in late 2016 to build in ‘17. So we think we have enough capacity to meet both enterprise and consumer demand through 2018.
As it relates to your second question, consistent with our historic practice we don't comment on rumors or speculation in the press but what we said in the past is that we continue to be the market leader, the innovator in this space and the only company at scale creating profitable revenue streams off of photos in the ecosystem and we are proud of what the team has built over the last 15 years and we are approaching a billion dollars in revenue with healthy EBITDA margins. So every day we wake up and think about how do we grow the ultimate size of the franchise deliver excellent value and innovation and service to our customers and then delight our shareholders over the long term.
Our next question comes from Youssef Squali with Cantor Fitzgerald.
Youssef Squali – Cantor Fitzgerald
Two questions starting with you Brian. How much of the EBITDA outperformance versus your own expectations was from the pushback of these expenses that you talked about in Q3. I guess related to that as we look at 2015 I know you are not guiding for 2015 just yet but as you're looking at the leveraging the model, Jeff maybe can you just address the need to I guess invest ahead of further growth in 2015 or would most of the increase in revenues translate into just a higher margin? And lastly on the organic growth and I know this is somewhat of a topical issue for you guys but maybe whether you look at it on an organic growth basis or on a pro forma basis we've seen your reported consumer revenues accelerate this quarter. Does that translate into an acceleration of your organic growth as well or pro forma growth whichever you want to look at?
This is Jeff, let me try to tackle the last two here of your questions. So and I'll take that third one first. We were very pleased by the growth on our core Shutterfly brand during the quarter, typically we don't give out those metrics. But there's been quite a bit of confusion in the marketplace, coming out of I think one bank – mid to low single digit growth for Shutterfly. So we wanted to try to dispel the confusion in the marketplace, so we gave it this quarter only at 21%. So we are proud of that and keep in mind we had four giftgiving holidays during this quarter Easter, Mother's Day, Father's Day and graduation, we’re entering into the seasonally slow third quarter with limited number of giftgiving occasions and then we come back into the fourth quarter.
So as we've seen over the last few years in the seasonally strong periods, our peaks are going up and then the trough there is slower growth. So we’re pleased by the overall mix, we are not forecasting what that means for organic or pro forma growth going forward. But we want to give you guys the data point there. And then obviously since we give you the overall consumers growing at 20% that would imply that Tiny Prints and Wedding Paper Divas grew slower than Shutterfly in the quarter and they are still continuing to face the headwinds related to the loss of the Costco relationship. As we look out into 2015 and the margins, certainly 2013 and ‘14 have been heavy investment years for us and our co-lo relocation, now opening of Fort Mill And Shakopee, our investments in ThisLife, our investments treat enterprise and wedding and we think that they will subside to a degree as we enter into 2015, we still have the Arizona launch and will continue to innovate a new feature functionalities, new businesses but we think that the margins will expand in 2015 from an EBITDA standpoint relative to 2014, not in a position today to give the order and the magnitude of that increase but we do think that we will start to get leverage out of the investments we’re making.
And then in the current quarter the EBITDA relative to our guidance as Brian mentioned in the prepared remarks was related to both the delay of some marketing initiatives, we’re going to turn on the marketing process for ThisLife next week so that that got delayed a week or two because of the co-lo, lighting of the colour in Las Vegas last week and some of that was related to slower hiring than we anticipated and some of that was just from a leverage that we’re getting in the model given the capacity utilization we were getting from additional in-sourcing as well as further utilization by Fort Mill. So pleased by where the business is executing, Q3 we’re investing ahead of the fourth quarter in terms of new products to the site headcount, servers, bandwidth and storage for ThisLife launch and in anticipation of our seasonally strong fourth quarter.
This is Brian, one clarification to as well, it does start in the current period quarter, the results started with the gross margin improvement 137 basis points year on year, that did come from efficiencies and material labor and shipping related for Fort Mill that was already online and since we really started the Shakopee investment very late in the quarter really for the most starting in Q3, that’s where you see some of that shift of cost as well where there is very little incremental cost toward the tail end of Q2 and that will really hit in the full quarter of investment as that ramps up in Shakopee in Q3 and you can see reflected in the Q3 guidance.
Our next question comes from Colin Sebastian with Robert Baird.
Colin Sebastian – Robert Baird
I guess first off as a follow up on ThisLife obviously just coming out of beta test but from a functionality perspective as well as usage and monetization, curious what your current view is on the performance of the application and is the subscription model something that you feel comfortable sticking with? And then secondly Jeff, clearly multiple growth opportunities ahead on multiple fronts, on one hand curious on the enterprise business what might be the situation there relative to little of the slowdown? And then more broadly speaking are you comfortable with the pace of investment the company's on right now or do you think Shutter fly will be better off maintaining a steady rate or heavier rate of investment?
So we are full week out of beta, so not a whole lot of data but – when we have robust data we will start to share with you guys some KPIs. But I will give you qualitative assessment, customers love it and the comments we’re getting is like where has this been my whole life, this is solving a huge problem, I don't have to beg my husband for the photos off this device anymore. I am able to share with my friends and families, it’s making product creation even easier. So it's hitting all the frictions and touch points of where we were hoping with consumers. The consumer feedback has been good. The conversion rate of paid has been quite good for freemium model, so we’re pleased with that, early days obviously and limited data but pleased with that.
And as it relates to the business model what I said in the past is we’re going out with a subscription model because it's a memory management application that comes with cloud storage, it’s not a cloud storage play per se and we think it adds additional value to consumers. As we start to add more of the commerce modules into ThisLife over the next 2 to 3 quarters and if we see a market increase in the conversion rates then we are very open to lowering the subscription price or even going to zero because unlike many of the pure cloud storage players who are just dependent on a subscription we have to back and monetization through the e-commerce. So the velocity on the platform increases sufficient that we think that's in the best interest of maximizing shareholder return. We are open to that but we're going to go and test and we figured you can always lower prices, it’s harder to raise it and in the early days people are taking us up on the subscription in a much higher rate people are taking us up on the $139 subscription rate versus the $59, so that’s been an early positive, again very limited data but early positive.
On the enterprise we’re working with a couple large Fortune 50, Fortune 100 companies on some big initiatives and this quarter's been about building the capabilities in terms of technology and service delivery as we continue to close those deals. And so the growth year-over-year in Q1 and Q2 were lower than we would have liked but the pipeline for Q3 and Q4 looks quite robust and so our prepared remarks we had talked about our anticipation of seeing increased year-over-year growth rates and we remain comfortable with that point of view and excited about enterprise as a long-term business for us as it continues to scale nicely and utilize our available capacity and our unique skill set.
In terms of pace of innovation, we still think there's a lot of runway across our multiple markets and now multiple brands. And we think we’re at a good pace of investment, you got to balance what the team is capable of handling from an execution standpoint, you balance that against the desire to grow both the top and bottom line at a measured pace and you balance that against your resources in terms of your balance sheet and your P&L. And we have plenty of cash, we have access to additional cash, so it's not really one of capital, it’s really one of going at a measured pace to make sure that we execute flawlessly as against our historical delivery and that we do it in a way that’s sustainable on an ROI basis. Other companies take a different approach, they go out and spend in marketing to acquire customers unprofitably and then they grow their topline but with very limited profitability and the street has been rewarding that for the last two years, but we think over long-term our strategy of a very ROI focused methodical approach to acquiring profitable customers is in the best interest over the long term.
The next question comes from Paul Bieber of Bank of America.
Paul Bieber – BofA Merrill Lynch
Just following up on Colin’s question, what are some of the goals that you have for ThisLife over the next three to six months as you roll out the marketing campaign? And then secondly, as we head into Q4 what are you doing differently this year versus last year, so you run into execution initiatives similar to what happened last year with Tiny Prints?
So the goals for ThisLife – I will talk about both the consumer and the competitive positioning goals and then I will talk about kind of financial and business objectives. We recognize a very large problem in consumers lives today which is increased volume of personalized content in the form of photos and videos that are fragmented across the bison ecosystem and a desire to do more with those photos than having them simply in the proverbial digital shoebox and we think ThisLife is an elegant solution that's meeting the needs of customers in a way that’s sufficient for them to take out their credit card and pay us. We are doing it under our umbrella of the Shutterfly Inc. brand that have a lot of equity in helping people do more with their memories. So we think we’re well-positioned given our brand equity, given our cost structure relative to storage, given our robust number of customers in our brand and across the portfolio brands and then available in the marketplace.
So we’re excited about solving that big problem because we think we’re uniquely positioned to do so. What we’re looking for from a business metrics standpoint is acquisition, how many people are downloading the application, we are looking for engagement, how many people are utilizing it on a frequent basis, are they doing that on a desktop, on a tablet or on a mobile phone, which ecosystems are they doing that? Kindle, Android, iOS? How many people in the family are linked to the same account. We are looking at commerce, is it driving increased commerce and velocity of commerce and transactions. How many people are sharing from it, how many people are virally telling people. So we have a whole dashboard of different metrics and as we get robust data we will start to give you guys a couple KPIs so that you understand that the progress there.
And then from on P&L standpoint we’re looking to both augment our commerce, revenue streams with potential subscription revenue stream that's ratable -- recognized revenue ratably versus seasonally strong in the fourth quarter and we’re looking to further differentiate ourselves to acquire customers, locking customers and increase the lifetime value of our existing customers.
With respect to Q4 in execution last year I think there were three things that hit us. One was the loss of Costco that was a strategic decision that I think was in the best interest of the company. The second was a technology glitch in the order management system and we fixed that glitch, and the third was because we were having that order management system we increased our outsourcing with a particular partner who didn’t need our SLAs and our expectations and so this year we’re taking in even more of the volume that we've historically outsourced. In fact looking at nearly hundred percent of all cards production for the Tiny Prints brand to now be in-housed. So we believe we fixed those executional errors and we teed up well for the strong holiday season.
And Paul, this is Brian, I would also finish with – you can see reflected in our guidance with the ramping up of headcount for the facilities and we’re actually having a little bit more full time equivalents versus temporary in those facilities, especially with respect to Tiny Prints and Shutterfly both with our expectation that we will have a little bit more upsell or continue to upsell towards – for card and stationary for finishing – for customized finishing and that does require a little bit of labor. So you see that reflected into our -- some of the numbers in gross margin and particularly as we ramp up in Q3 into the peak season in Q4.
Our next question comes from Rohit Kulkarni with RBC Capital.
Rohit Kulkarni – RBC Capital Markets
Quick question on enterprise -- can you talk about anything that you can do there or wish to do there to perhaps accelerate the growth – there has been 4, 5, 6% year on year growth for a while, is there other more investments that you can do or wish to do that could take it to a more accelerating growth level or is there something structural or market related that kind of capture right there? And mobile has been doubled on the Shutterfly brand and I guess what are the use cases that you think are in your opinion are being very successful for you – and do you think that is something that is also becoming a good customer acquisition too for you?
As I marked to Colin’s question about enterprise, we saw less than expected growth in enterprise for Q1 and Q2 but that was noble from us from some existing customers who are planning on pushing out some of their programs into Q3 and Q4. Plus we’ve been increasing our technology investments in enterprise so that we can create more platforms, like other SaaS or ERP companies that will be embedded into these large corporations which we think will help us win backoffs and then also increase the amount of work and the stickiness with our existing customers. So we've taken a longer-term investment approach to go out and build these set of capabilities so that we can grow enterprise even larger in a more sustained level and given where the pipeline is and the commitments from some of our current customers we feel very good about the growth rates as we enter into Q3 and Q4 and some of that is reflected in the Q3 gross margin guidance because we’re expecting a acceleration of growth in enterprise that has lower gross margin and lower EBITDA margin but increased free cash flow and EBITDA dollars.
Other things that we’re doing in enterprise, we’re looking at expanding our sales force as well as potential M&A to increase the set of capabilities and the customer set. Mobile, we’re pleased with the growth in Shutterfly up more than 100% year-over-year on that, the use cases are not that dissimilar from our traditional customers though they tend to be more simple-based projects because you can’t make a photo book in a smartphone app today, you can obviously on our photostory app for the iPad and on the desktop and so you see a slightly lower average order value in our smartphone app because it’s more premium photo gift base but we’re pleased by both the adoption, the pace of monetization as well as the fact that it's acquiring new customers that have never purchased across the Shutterfly Inc. family of brands. So it’s acting as a expansion tool to our current set of demographics that are historically come through the web-based PC-based experience. So we will continue to make meaningful investments in mobile, we’re working on apps for the other brands, that's why we give data for Shutterfly because we haven’t had apps for the other brands. That is coming shortly and we’re excited about those investments.
Rohit Kulkarni – RBC Capital Markets
If I could – I had just one more quick question on videos on the sharing app ThisLife, what could be the potential ways that you could make money off of those, is that largely from consumer engagement stickiness, lifetime value and cross-selling other products or anything that you could eventually do from just video side of things?
Yes, so I think the first way you monetize video is through the subscriptions revenue stream and then we’re exploring other opportunities by ability to take stills out of the video and create product, we are looking at multimedia mashups between photos videos and music and allows you the digital manifestation but the ability to monetize video in the ecosystem is more limited than photos today. But technology will continue to change, consumer behavior will continue to change and we will continue to innovate around that. But the primary way we’re going to have to monetize it directly would be through the subscription and then indirectly through greater locking of our customers and greater lifetime value through the other things that we’re able to upsell and cross-sell it.
Our next question comes from Kerry Rice with Needham.
Kerry Rice – Needham & Company
A couple of maybe a high level questions, Q3 typically as you had mentioned earlier does is not have as many giftgiving holidays or giftgiving days, can you talk a little about your playbook in Q3? Do you generally run a lot more promotions or given the data that you guys have, can you really use that to target in on your key customer, so maybe promotions won't be as much as they have been in the past? And then second question is there's been some M&A activity kind of in the periphery space to you where on the white label side, Staples acquired a small company, that has won some business there. With Staples acquiring them, have you guys thought about ever filling the gap there and moving into some more white label type of businesses and if not, have you seen any change maybe in the ecosystem there like HP becoming more active around Snapfish?
Our customers are on vacation during the third quarter creating their memories and when they get back and mom gets the kids back into school and she starts having little bit of me time again at 9 o'clock at tonight she starts to take those memories and create everlasting gifts and preserve those memories for herself and the family. And so we started to see a reacceleration as we enter into the third quarter. That cadence has been consistent for the 15 years that we've been in business and operating and so what we tried to do in the third quarter is spur demand in more of a artificial way than based upon traditional giftgiving. And so you see a difference promotional cadence from us during the third quarter than you do in the second or the fourth quarter. And so I don’t think much will change this Q3 over historical patterns. We certainly have a different arrow in the quiver this quarter as we start to market ThisLife and try to get them to download app to start to manage and collect their memories but again getting people focused, half of Wall Street's have been mom is in the Madison Wisconsin at the Waterpark, so we use promotions to try to spur that demand and that's reflected in our guidance on the top and the gross margin and the EBITDA margin line.
In terms of M&A in the space, [Ken and I] have been in business for a long time, they’ve had four or five competitors over the year, so SilverWire which got picked by HP, Lifepics which got picked by [Keller] Publishing and a couple other, EZprints,that got picked up by CafePress. These were also sub $30 million and in some cases sub $10 million technology enablement companies that didn’t have very robust business models because they were being used by large retailers who basically were paying it on a nonrecurring engineering basis and had limited strategic flexibility. Snapfish has been white label player in the ecosystem for Wal-Mart and Walgreens and historically CVS and Costco and other players, as they lost that business P&I kind of filled that void.
Shutterfly when I joined the company nearly 10 years ago, we used to white label for BestBuy and Yahoo! And Dot Photo and Creative Memories and others and I shut that business down because it made no sense for us to subjugate our relationship with the consumer to a third-party and not build a premium brand. So we're sticking to that strategy, we have no interest being white labeling our better user experience, our better quality of manufacturing, our innovation, our user experience, our CRM, our conversion funnels, for anyone else on the white label. But we’re delighted to do that in cobranded ways, we do with our partner Target and other people from time to time. So we will continue to explore opportunities do that in a cobranded way. Quite the opposite, we haven't seen SnapFish winning work, we've seen HP deemphasizing Snapfish, they have shutdown six or seven of their international sites and some of their white label partners have been going direct because HP hasn’t been making the same investments in that platform to stay current to Shutterfly or other small players. So we will continue to talk and work with our retail partners as we offer pick up in store. We have cobranded relationships with Target. We always have conversations with those folks about ways to expand both of our businesses but it will not be in a white label basis.
This is Brian, one last thing on the Q3 playbook, I think what we will continue to do as Jeff mentioned in his prepared remarks is use Q3 as an opportunity to offer up more photo gifts and home décor products which has been very fast growing for us. So coupling that level of investment by pushing that out into more mobile-based offering, so making more of those home décor and photo gift products available on a mobile device and actually using much more intelligent mobile customer analytics and push notifications from a CRM perspective. So that will be I think mobile and home décor and photo gifts in general will be a continuing theme that you will see -- beginning to start a little bit more heavily in Q3 going in Q4.
Our next question comes from Mitch Bartlett with Craig-Hallum.
Mitchell Bartlett – Craig-Hallum Capital
Most of the questions have been well traversed at this point but I did pick up on the fact that you said I think that by Q4 Tiny Prints will have a 100% of their volume insourced. What does that compare to last year with all the issues that – and that should be a fairly dramatic increase in gross profit flow through to you, so maybe you could talk to that?
Mitch, my comment was specifically about cards for TinyPrints which is still predominantly large proportional of the total revenue. Last year we had approximately 75% of its cards volume done in our own operated manufacturing facilities, and this year our target is a 100%.
Mitchell Bartlett – Craig-Hallum Capital
There were some issues that caused some charges associated with that on volume.
Yeah, there were two things. One is we had this glitch in the system that were saying that orders were produced and customers are saying they hadn’t received it, we kept reprinting it overloading our internal capacity, we outsourced more, so last year you had a little bit of rework, you had some loss sales and you had additional cost with the outsource partner, so we will hopefully capture back some of that margin this year, offset by the free gift that we gave to Tiny Prints customers in the beginning of this year as a $50 credit saying sorry for the mis-execution but use this card any time in the year and we expect most of them have been saving that up for the fourth quarter. So we will capture back some of that margin but not all of it offset by the $50 gift card but all things being equal the margin on the Tiny Prints cards business will increase in the fourth year over year.
Mitchell Bartlett – Craig-Hallum Capital
And just looking at your average customer, your heavy using customer on the core Shutterfly brand, has – is she still doing basically the same stuff that she has been doing year after year or is there an elevation – is there new stuff that they are exploring and gravitating to – is there any fatigue over time versus exploring new stuff?
It’s actually both, we are seeing our core customer she still wants to do it beautiful card for the holiday season but she is taking advantage of some of our new feature functionality, so maybe our foil cards and maybe rounded or scale up edges, it might be personalized envelope liners, it might be match back address labels, or customized stamps, so she is taking advantage of kind of what’s new but she still wants tradition which is to be able to communicate about her family during the holiday season. She also wants to do that calendar every year because it’s kind of the part of the family and the grandparents wants it but she is also now saying, wow, Shutterfly is offering me this year between the beginning and the end of the year we will have something close to a 125, 150 new products that will have come out across the year and so she is saying, wow, I can decorate my home with wood, or metal or curve glass or frame canvas, I could do personalized pillows or launch boxes or growth charts or pillable wall stickers, so she is starting to see Shutterfly where she might have seen us seven years ago as her photo printing company and photo sharing company to really being the company I go to when I want to uniquely touch someone’s heard, when I want to give that personalized gift, when I want to adorn my home with my memories, when I want to create a unique environment during the holiday so the answer is both, she is doing some of the traditional stuff with a modern flair but she is also taking out her credit card and we are getting expanded share of wallet from her, she thinks about us in more of a personalized product framework, not just the photo framework.
Our next question comes from Trisha Dill with Wells Fargo.
Trisha Dill – Wells Fargo Securities
Just first on the new production facility you mentioned it allowing for next day delivery this holiday, can you just elaborate on that point in terms of what that means in terms of brands and products that will be eligible and I guess more generally overall how your new infrastructure this holiday season will impact order deadlines and delivery times relative to last year, and how much of a driver you think that can be laid in the season?
So last year was a tough Q4 for retailers as we lost six shopping days and well, every retail company keeps trying to pull demand forward, where it used to black Friday and cyber Monday, now it’s – people are doing holiday before Halloween even comes around and so everyone is trying to pull demand forward but the consumer keeps waiting later and later. And last year we had six less shopping days, this year we get one back, so that’s positive. And as we round out our footprint across the US, our ability to get people for example on the Tiny Prints brand to choose super rush, where they go to the front of the production line plus they get the next day delivery increases and we are hopeful the take rate goes up because that’s nice margin for us. So as we expand our footprint, on our balance sheet we think that gives us demonstrable competitive advantage against other ecommerce players in our space and it starts to get us towards parity with the impulse buy of walking into retail. And so that’s the long term strategy not dissimilar from what Amazon is trying to do with next day delivery or even same day delivery in their case, standardized excuse that they don’t need to be manufactured, but we want to reduce any of the friction points between us and offline because remember 80% to 90% of all the economic range in our addressable market still occur in retail. So we are trying to make ourselves more competitive by having more design choice, more platforms allowing people to do it anywhere any time and being able to get the products to them in a high quality high personalized way as quick as possible. So we haven’t modelled for the street what we think that impact is, it’s in our full year numbers but we do believe it’s a positive impact for us from a margin standpoint and a competitive differentiation.
Our next question comes from Shawn Milne with Janney Capital Markets.
Shawn Milne – Janney Montgomery
Just a couple quick ones, Jeff, I know it’s really early still with ThisLife, is there anything that you are learning on the product creation side that you might be able to bring back into the core business? And then Brian, just on the revenue guidance for the second half, maybe my math is a little bit off, but if you are expecting a big acceleration in the enterprise business, it looks like you are thinking an deceleration on the consumer side, and I know you talked about Q3 as fewer holidays but it seems to us like this fourth quarter would be an easier comps for you, I wonder if you could give a little more color on that.
So there is nothing specific around the ThisLife’s learnings that impact the core business but keep in mind as I said publicly before it’s ThisLife by Shutterfly and over time ThisLife and Shutterfly come together in a new unique experience to create essentially Shutterfly 3.0 and so the early part of the consumer funnel in terms of how do I aggregate my photos, edit my photos, select my photos, curate my photos and share my photos, ThisLife I think is a better experience than what’s available on the core Shutterfly platform today and then Shutterfly has the creation paths and the product creation and the ecommerce capabilities and so we think a marriage of those two platforms over time creates a better and unique value proposition in the marketplace. The guidance on enterprise does as the acceleration in Q3 is reflected in a decrease in the gross margins for the third quarter and does reflect a deceleration in the growth in the consumer business because it’s not that there are fewer holidays, there are no holidays in the third quarter and so that is consistent with historical patterns. Q4 gets a little bit easier for us from a Costco lapping on Tiny Prints and one more shopping day but we are still a good five months away from that seasonally strong December. So we think our guidance accurately reflects our belief about what we will do today and keep in mind we increased the lower end of the guidance range as we rolled out of Q2 with the experience of the first half.
Our next question comes from Victor Anthony, Topeka Capital Markets,
Victor Anthony – Topeka Capital Markets
Question on your competitors, you caught up against [indiscernible] there were some charges with them. Who is your biggest competitor today, I mean who are your biggest competitors and what are you expecting from them as you head into the fourth quarter?
There is no one single competitor in our current core space that has the same kind of market share, innovation and quality, ecommerce ability. So I would say our biggest competitor in general is retail and consumer behaviour. So for decades they have been walking into retail, they drop-off their roll of film, and they are there for other occasions during the holidays, so there is the convenience factor of buying that box of non-personalized cards, or dropping off their memory stick at the counter while they are doing other shopping. So biggest competitor is changing consumer behaviour to show them all the things that you could do online and on our platform that you can’t get in retail. That’s from a design standpoint. From the use of creation, from a home décor, from finishing to quality to photo storage, photo sharing, photo editing and all the things that we provide the most retailers don’t. That’s our biggest competitor changing consumer behaviour, getting more of that economic rinse from offline and generic to online and personalized.
Our next question comes from Chris Merwin with Barclays.
Chris Merwin – Barclays Capital
So for ThisLife, have you started to ramp up spending on user acquisition at all? Just wondering if you could provide any details around your marketing strategy for that product and what channels in particular you think you might go through, and any takeaways from testing that you've done so far. And then in terms of convergent, what percentage of ThisLife users so far have converted to being e-commerce customers?
So as we said, Chris, in the prepared remarks, we haven’t launched the marketing spend at all, that happens next week and we are going to do that online, we are going to do that inbox, we are going to do that onsite, we are going to do that on radio, we are going to do theater, movie theaters, we are going to do house parties, we are going to do that through partnerships, we are going to do that through direct mail. So it’s a truly integrated marketing approach and what our plan is to spend some money in the third quarter, figure out which channels work for a piece of software and application versus ecommerce, make sure that we understand any of the nuances there. We will dial back some of that expenditures as we get into the seasonally strong fourth quarter and then based upon those learnings and the launch of more functionality in the early part of Q1 on ThisLife we will then turn back up the marketing spigot. So I don’t have any data to share with you because we haven’t launched it just yet.
As it relates to users turning into customers, we haven’t disclosed those metrics and as I said as we get a robust and statistically significant enough data set and a history, that smooths out some of the start up noise, we will come back and give you guys some of the KPIs around how ThisLife is performing.
Our next question comes from Brian Fitzgerald with Jefferies.
Brian Fitzgerald – Jefferies & Co.
You talked quite a bit about ThisLife. So appreciate that. Maybe you mentioned rolling out the e-commerce models over time there. Should the cadence around that be pretty steady, or is it going to be that the heavy lifting is done first and it should accelerate? When should we see it fully integrated into ThisLife?
So you can’t make product out of ThisLife today, you select your photos, you go up into the upper nav and you click on create and then it transfers your photos into Shutterfly into the specific creation path, with the photos you selected. So it’s a good user experience. Our objective and goals is to make that a amazing experience and that will start to occur kind of in Q1, Q2 of next year. And so we think we will get additional commerce benefit in the interim period but we think that will accelerate when we launch some of our auto creation and some of the new UI that we are contemplating next year.
Our last question comes from Kevin Kopelman with Cowen and Company.
Kevin Kopelman – Cowen and Company
Could you talk about what changed between your expectations now and your expectations as of the Q1 call that caused you to lower your gross profit guidance for the full year?
This is Brian, so I think the main driver of that was the little bit of greater mix in enterprise, little bit more depreciation coming from the ramp up of facilities in both Shakopee and then the continued scaling of Fort Mill and as I mentioned on an earlier – in response to an earlier question we are ramping up a little bit more on labor in the facilities, some precautionary, some with expected upsell, greater upsell activity in cards and stationary for both Shutterfly and Tiny Prints and doing that a little bit earlier to get fully ready, get some more full time employees on the ground versus the traditional ramp up through temporaries, and then lastly we do have overall efficiencies in there for the year which is still going to be reflected in the volume, so overall volume and efficiencies are going to be offset through that incremental cost on the gross margin from the enterprise and Shakopee ramp up. Lastly product mix is a factor as well. We are expecting to have more of those upsell products and the continued growth of photo gifts that was different from Q2, we are still seeing market acceleration in photo gift sales and those are typically outsourced as you know.
Thank you. This ends the Q&A session for today. I will turn it back to management for closing remarks.
Thanks everyone for joining us today in our Q2 2004 earnings call. We had a really good quarter, we saw acceleration of growth in the Shutterfly brand, we continue to invest for future scale and differentiation both in our user experience as well as our technology platform and our manufacturing footprint. I remain very optimistic about our consumer and enterprise businesses as we enter into the back half of 2014 as well as the launch of our new ThisLife money management application and the ability to attract new customers and increase the life time value of the customers over the long term. So we look forward to talking to you guys on the road over the next few weeks and appreciate you joining us today.
Ladies and gentlemen thanks for participating in today’s program. This concludes the program, you may all disconnect.