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Shutterfly, Inc. (NASDAQ:SFLY)

Q4 2010 Earnings Call

February 2, 2011 5:00 PM ET

Executives

John Kaelle – Vice President, Finance

Jeff Housenbold – Chief Executive Officer

Mark Rubash – Chief Financial Officer

Analysts

Jim Friedland – Cowen and Company

Youssef Squali – Jeffries & Company

Shawn Milne – Janney Capital Markets

Mitch Bartlett – Craig-Hallum

Colin Sebastian – Lazard

Aaron Kessler – ThinkEquity

James Cakmak – Sidoti

Heath Terry – Canaccord

Operator

Good day, ladies and gentlemen. And welcome to the Shutterfly Fourth Quarter and Full Year 2010 Financial Results Conference Call. At this time, all participants are in a listen-only mode. Later, we’ll conduct a question-and-answer session, and instructions will follow at that time. (Operator Instructions)

As a reminder, this conference is being recorded. And now, I’ll turn the program over to John Kaelle, Vice President of Finance with Shutterfly. Please go ahead.

John Kaelle

Thank you, Operator. Good afternoon, everyone. And welcome to Shutterfly’s fourth quarter and full year 2010 conference call. With us today are Jeff Housenbold, Chief Executive Officer of 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. Also released some visuals that we’ll use as we go through the call. Additionally, within a few hours we will release a recording of this call, both in a streaming online format and through a downloadable podcast. You can access all of these through the Investor Relations section of our website at shutterfly.com.

Before we begin, I’d like to note that our discussion today will include forward-looking statements within the meaning of the Securities Act of 1933 and the Securities and 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 -- risks relating to our business in general, we refer you to the sections entitled Risk Factors in the company’s last annual report on Form 10-K and its filings with the SEC. I’d 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 of measures made by other companies. The quantitative reconciliation of these non-GAAP financial measures to the most directly comparable GAAP financial measures is available in our fourth quarter and full year 2010 earnings press release, which is posted on the Investor Relations section of our website at shutterfly.com.

Now, I’d like to turn the call over to Shutterfly’s CEO, Jeff Housenbold.

Jeff Housenbold

Thanks, John, and welcome, everyone. I’ll start out comments today with an overview of our 2010 results together with some comments on our strategy as we enter 2011. I’ll then turn the call over to Mark for a detailed review of our Q4 and full year 2010 financial performance, as well as our initial financial guidance for 2011. We’ll then open up the call for your questions.

As you listen to our remarks today, I’d like you to keep in mind these key messages. First, we continue to see very solid growth rates and increasing contributions from our award-winning line of photo books and cards and stationery products, and from our private personalized Shutterfly share sites.

The revenue growth we have seen throughout the year and the accelerating growth we’ve seen from our core personalized products confirms that our strategy is on target and that we are continuing to delight our customers with unique, stylish and creative ways to stay connected to the people that matter most in their lives.

Second, throughout 2010 and continuing into 2011, we have been making meaningful investments in key areas of our business. These investments have and will continue to improve our platform and storage architectures, strengthen our image rendering and e-commerce capabilities, and support new product, feature and design improvements.

We believe these innovations will continue to provide our customers with an elegant user experience and on trend design forward products while further differentiating our brand and strengthening our competitive position.

And third, consistent execution against our key strategic initiatives letting us focus on the customer and strong financial discipline once again resulting in record financial results for Q4 2010. During Q4, we delivered $166 million in net revenues, representing a 27% year-over-year increase. For the full year 2010, we increased net revenues by 25% to a record $308 million. This outstanding performance was lead once again by accelerating year-over-year growth in personalized products and services, and the loyal support of our 4 million active customers.

Now, I’ll briefly recap some of the progress we made throughout the year starting with our products. As I mentioned earlier, throughout 2010, we made a number of investments in our photo book product line that continue to differentiate Shutterfly and extend our lead in our flagship category.

We focused on enhancing the user experience and expanding the design options for customers by making it easier and faster for customers to create a photo book, regardless of where their photos are stored.

We launched our universal picture picker allowing users to select photos from various sources like My Shutterfly, Share Sites, Facebook, Picasa and directly from their computers. In our Simple Path creation experience we continue to improve our auto fill algorithm, increase layout options and adding many new styles and fresh designs. As a result, Shutterfly’s photo book customers continue to receive the greatest choice and the highest quality photo book experience in the market.

And finally, we made outstanding progress on an entirely new photo book platform that will launch in the first half of this year. Our goal is to make the photo book creation experience accessible, fun, fast and stylish to beginners and experts alike, so stay tuned.

Turning now to cards and stationery, in 2010, we continue to improve the customer shopping experience and expand the breath and depth of our cards and stationery collection. We enhanced our actively based navigation tools making it faster and easier to customers to refine their card choice based on elements such as cards format, number of pictures, paper type, card size, card color, card design and price. We introduced new form factors including a sophisticated five by five square card across numerous occasions and enhanced our three by five folded note cards with more design and layout options.

From a design perspective, we introduced cards for many new occasions including birthday, Easter, Baptism, First Communion and Bar/Bat Mitzvah. And for the Q4 holiday season, we launched our largest card collection yet with more than 1400 classic, modern and fun holiday designs.

The holiday collection was met with great reviews from customers and top media outlets like The Wall Street Journal, (inaudible) and the Ellen DeGeneres show. As we look to 2011, we will continue to enhance the shopping experience and design assortment making it easier for customers to find the perfect card to celebrate their personal style and occasion.

In the photo gifts category, we expanded our product offerings with many fresh on trend gifting solutions. We redesigned our calendar line-up, introduced a new sophisticated desk calendar and added new features and dozens of new designs to our calendar collection.

On our wall calendars, we incorporated design and personalization onto the lower grid, adding the ability to customize specific days with text and photos. Early in 2010, we introduced wall decals, life-sized peel-and-stick photo cutouts that come in 3, 4 and 5-foot sizes.

We also added elevated design options for existing photo gifts like mugs and mousepads, and added features like 3D preview. Just in time for Q4, we unveiled our home décor collection that helps consumers turn their favorite images into personalized art work for their homes. The collection includes mounted wall art and desktop plaques, as well as expanded canvas print choices.

In addition to enhancing our product assortment, we continue to drive customer acquisition and engagement through our feature enrich services. During the year, we continued to invest in our largest service, Shutterfly Share Sites. The goal of Shutterfly Share Sites is to be the best place on the web where family, friends and groups can create their own secure website, stay connected and share their memories.

Our sharing platform combines the power and the benefits of photo and video sharing, blogging, self-publishing and social networking sites, combined with a sophisticated security layer and an easy to use interface.

In 2010, we improved our comprehensive offering for youth sports teams and classrooms. In Q1 we introduced the youth sports module and announced a partnership with Washington Youth Soccer and in August, we partnered with AYSO, the largest youth soccer organization in the U.S. to provide team members with personalized team websites.

We developed an easy to use custom wizard that enables coaches to quickly name their site, choose their team color, validate their roster and schedule a calendar of events. These private secure websites are members only and are endorsed by the AYSO’s Safe Haven program.

Our Share Sites provide parents a central location to access integrated game and practice schedules with automatic e-mail reminders, sign up for snack duty and update volunteer availability, and contact information.

In time for the back-to-school season and to help parents stay connected to their kid’s teachers and schools, we added new features to our Classroom Share Sites. The Classroom Share Sites are private and offer a variety of features that save time by removing the hassle of paper sign-ups and numerous back and forth e-mails.

Members can post contact information for teachers, room parents and other key volunteers class list with each child’s parent contact information, and a picture so everyone knows who is who. The new volunteer section makes it easy to match up parents with the needs of the classroom, enabling online sign-ups for things like teacher’s wish lists, potlucks, field trip chaperones and teacher-parent conferences.

The classroom calendar helps keep everyone in the loop by sending electronic reminders about important upcoming class events. Shutterfly classroom websites also make it easy for teachers to post photos, videos, class news, homework assignments, class handouts and school information.

In addition to youth sports and classrooms, we added features to our Baby Share Sites. These enhancements make it even easier to create and customize a site, while giving new and expecting parent’s easy ways to share important milestones with friends and family. Additionally, we’ve created 12 new Baby Share Site designs that coordinate with our both announcements, allowing new parents to celebrate their baby’s arrival in style.

On our Wedding Share Sites, we partnered with The Knot and the WeddingChannel to introduce an integrated gift registry tool. This feature makes it easy for brides and grooms to integrate gift registries into their Share Site, making it a one-stop personalized destination for wedding memories and information sharing with family and guests.

And finally, we also introduced various site features across all Share Site categories, featuring integration with Facebook Connect. This allows Share Site visitors to sign into their Facebook accounts to leave comments on photos, albums, videos, journals, photo books and the activity feeds, without having to create a Shutterfly account.

We launched picture tagging which was instantly successful with customers, where users can now tag and search photos making product creation easier. We also added e-mail address import, enabling users to import contacts from Outlook, Outlook Express and Mac Address Book.

From the business model standpoint, Share Sites are driving customer acquisition and loyalty, product sales and while still in the early stages, advertising and subscription revenues. Share Site’s adoption continues to grow in the end of the quarter with nearly 2.8 million Share Sites and accelerating year-over-year growth in the number of shares sent.

Moving on to other services, we made significant enhancements to our video hosting service by partnering with Sorenson Media. As a result, our customers now benefit from greater video performance, stability and an improved overall user experience.

In July, we also introduced our Express Uploader to give customers the choice of uploading photos at three different resolutions and speeds up to four times faster. The Express Uploader has become one of our fastest adopted features and is now contributing to a much improved user experience, as well as increasing efficiency of our storage platform.

Lastly from a services point of view, we continue to build applications for desktops, laptops and mobile devices on both Mac and PC platforms to give consumers the ability to take their photos with them, regardless of device, platform or location.

To compliment our applications for the iPhone, iPod Touch and Wink, we launched Shutterfly for iPad. Users can now use the free application to access Shutterfly albums and pictures, save them to their iPad, use stunning full screen slide shows, email pictures stored on Shutterfly and post photos from the iPad to their personalized Shutterfly Share Site for friends and family to enjoy.

Now, I’d like to briefly describe some of our accomplishments in business development, social media and commercial print. Throughout 2010 we have continued to partner with the leading companies to increase the awareness and adoption of Shutterfly products and services.

For example, our relationship with Sony gives VAIO customers instant access to Shutterfly photo books right on their desktop. We also partnered with leading retailers like Best Buy, Target, Walgreens, Target and CVS giving our customers more shopping options.

On the social media front, we continue to foster high levels of customer engagement by active participation on our Shutterfly blog, Facebook and Twitter pages. Since launching our presence on Facebook, our customers have responded positively to the content on our page, the opportunity to engage and share ideas with others and the chance to provide feedback directly to Shutterfly.

We continue to explore new ways to integrate our marketing programs with a social media component to leverage the loyal following we are building throughout the social sphere. At the end of 2010, our Facebook fan base totaled more than 185,000.

Now turning to our commercial print business, we made solid progress during the year, particularly given the tough macroeconomic climate and the early stage nature of the program. In November we acquired WMSG, expanding our capabilities and enabling a complete solution for variable digital print marketers. We believe this small but strategic acquisition will benefit our existing commercial clients and help enable faster growth in this large and growing market.

Finally, we have made great progress building a strong team of innovative entrepreneurial and action-oriented people, who have a relentless passion for winning. Not only has this team delivered a great customer experience and outstanding financial results, they’ve also contributed greatly to an organization that fosters trust, respect and individual contributions.

During 2010, the Shutterfly team was recognized by The Great Place to Work Institute, who named us one of the 25 best medium-sized companies to work for in America and by Glassdoor, who ranked us 14th in the nation in their list of the top 50 companies to work for in America. We were also named to Arizona’s Most Admired Companies by Arizona Business Magazine and Best Places to Work by the Charlotte Business Journal.

In closing, despite strong competition and a recovering economy, we finished 2010 with strong momentum in our key product and service offerings and we continue to execute on our strategy. With a strong focus on the customer, we made the right investments to gain market share through innovative and design forward product and services, customer friendly policies and industry-leading quality.

This approach combined with our commitment of solid execution and financial discipline will enable us to maintain our record of increased revenue, free cash flows and long-term shareholder value in 2011 and beyond.

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

Mark Rubash

Thanks Jeff. Before I begin my detailed comments, I’d like to once again extend my sincere thanks and congratulations to the entire team at Shutterfly, contributions to a very successful Q4 and full year 2010.

I continue to be impressed by their dedication, innovation and commitment to delivering outstanding products and services to our customers and record financial results to our shareholders. In short, I could not be more proud of our team and their achievements in 2010.

While there are many challenges that remain on the road to economic recovery, it has become increasingly clear that our product and services offerings are being adopted by an ever broadening range of consumers that our strategy is on target and that we can execute successfully even in challenging economic times.

During the past three years, we’ve increased our net revenues at an accelerating rate from $187 million in 2007 to a record $308 million in 2010. And at the topline growth is a significant achievement, our greatest sense of pride comes from also delivering a meaningful increase in adjusted EBITDA, profitability and free cash flows.

For the full year 2010, our adjusted EBITDA profitability hit a record 21.8% of revenues and free cash flows totaled a record $44.7 million, reflecting 38% year-over-year growth and a yield of 14.5% of net revenues.

So with that, let’s now go a bit further into our Q4 and full year 2010 financial results starting with our key metrics. During Q4, our key engagement metrics continue to reflect the very healthy trends we have seen over the past six quarters with solid activity during non-holiday periods and strong performance during the peak holiday shopping days.

Like most e-commerce companies October and November trends were fairly consistent with our historical patterns, except for the week of Thanksgiving which came in relatively strong. As expected, December was our strongest month of the quarter with peak period volumes extending to our last shipping cutoff prior to Christmas.

For the quarter site visits, unique uploaders and orders all showed strong accelerating year-over-year growth, with fairly consistent growth rates across the quarter. In addition, user registrations and the number of shares sent continued to stay on trend with consistent double-digit year-on-year growth.

During Q4 we had approximately 2.3 million transacting customers, who generated nearly 3.7 million orders with an average order value of $44.41. This transaction activity translated into 23% year-over-year growth in customers, 21% growth in order volumes and 5% growth in average order value. The improvement in average order value resulted largely from the continued shift in product mix from prints to higher value personalized products.

Let’s now move through a discussion of our reported results starting with net revenues. Net revenues for the quarter totaled $166.2 million, reflecting 27% year-over-year growth. The allocation of net revenues between new and existing customers was 27% and 72% respectively, consistent with Q4 of last year.

Net revenues for the quarter also included $2.3 million from our commercial print customers, including contributions from WMSG bringing the full year total for commercial print to $5.1 million. In terms of product mix, net revenues from personalized products and services and from prints totaled 75% and 24%, respectively. Also net revenues from 4x6 prints represented 5% of total net revenues, down from 7% in the prior year.

Personalized products and services increased 33% year-over-year, led by continued strong double-digit growth in photo books, as well as significant contributions from our cards and stationery collection, calendars and an improved selection of home décor products and photo merchandise. Total prints, which include silver halide greeting cards increased 10% year-over-year. The highest growth rate for prints since Q2 of 2008.

Moving to cost of net revenues and gross margins, we reported a gross margin of 62% during Q4, a modest improvement from the prior year and consistent with our expectations. This solid margin performance resulted from several factors including improved product mix, labor efficiencies from both our Charlotte and Phoenix manufacturing facilities and improvements in material costs, partially offset by promotional discounts, lower shipping margins and lower margin commercial print revenues.

Technology and development costs totaled $12.1 million for the quarter including a year-over-year decrease of $1.1 million in depreciation, amortization and stock-based compensation. The decline in depreciation and amortization expense reflects the significant improvements we’ve made over the past few years to reduce the capital intensity of our business.

Excluding these amounts our technology and development spending increased approximately $630,000 or about 7% from the prior year. The majority of this amount is attributed to headcount investments, with the balance primarily attributed to modest cost increases for power, co-location space and bandwidth.

Continuing down the income statement, sales and marketing expenses totaled $26.3 million in the quarter, representing 16% of net revenues compared to 14% in 2009. Substantially all of the year-over-year increase is associated with expanded online media, direct response and partner marketing campaigns with a smaller portion associated with expansion of our internal marketing team.

While our Q4 customer acquisition costs increased about 17% from the prior year, these cost increases were offset by strong growth in new customers and continued improvements in average order value per customer.

Total sales and marketing costs per customer in Q4 approximated $11, consistent with our historical trend and reflecting efficiencies realized from our Shutterfly share social networking platform and other viral marketing efforts.

General and administrative expenses for the quarter totaled $13.4 million or 8% of net revenues, compared to 10% of net revenues in Q4 of last year. Excluding stock-based compensation and credit card processing fees which vary with revenue volumes.

G&A expenses represented 4% of net revenues in the quarter down from 5% in Q4 2009. Quarterly G&A expenses included increases for our employee compensation, offset by lower costs for professional services and outside contractors.

Continuing the discussion, Q4 adjusted EBITDA totaled $60.2 million, far better than our guidance and a $12.3 million improvement from Q4 of last year. This continued growth in adjusted EBITDA profitability resulted from increased demand from our products and services, notable improvements in our product mix and consistent efforts to manage our cost structure in line with our revenue growth.

The effective tax rate for the quarter was 35.6%, bringing the full year rate to 32.1%, lower than our guidance -- as a result of ISO stock option benefits and from the recent extension of the federal R&D tax credit. On a GAAP basis, our net income totaled $32.5 million or $1.09 per share based on 29.9 million diluted shares.

Now, I’d like to provide some additional insight on our capital expenditures and on our cash investment and on our cash, investment and liquidity status. Capital expenditures during the quarter totaled $5.5 million, including $2.1 million for technology, $584,000 for manufacturing and building improvements and $2.8 million in capitalized development costs.

And finally, we finished the year with no debt and $252.2 million in available cash and investments. After adjusting for Q4 accounts payable that will be paid in Q1, we believe that our available funds are sufficient to meet our ongoing strategic and operating cash requirements.

To round out this part of the discussion, I’d like to summarize our full year 2010 results. Net revenues for the year totaled $307.7 million, a 25% year-over-year increase. During 2010 we had 4.1 million customers that placed nearly 9.2 million orders with an average order value of $32.88.

For the full year personalized products and services contributed 71% of net revenues and reflected a 35% year-over-year growth rate. Of particular note, our award winning line of photo book and cards and stationery products, including silver halide greeting cards, now account for more than 65% of our total net revenues and reflect a combined 2010 year-over-year growth rate of 40%.

Net revenues from prints increased 4% on the year and contributed 27% of net revenues, and revenues from 4x6 prints represented 10.4% of revenues, down from 14.5% in 2009. And finally, our commercial print initiative delivered $5.1 million or 1.7% of annual net revenues.

Our gross margin for the year increased 160 basis points to a record 56.3% reflecting an improved product mix, increased leverage of our fixed manufacturing base and meaningful improvements in labor efficiency and materials cost.

These structural efficiencies more than offset the investments we’ve made in two state-of-the-art manufacturing facilities and increasing contribution from lower margin commercial print, and the loss of $3.9 million in 100% margin referral fee revenues.

By carefully managing our operating costs and capital expenditures, we made great progress on the strategic investments necessary to grow and strengthen our business, while at the same time increasing our adjusted EBITDA profitability and substantially improving our free cash flows.

Our full year adjusted EBITDA profitability was 21.8% of net revenues, a clear improvement from the 20.4% rate in 2009. And our capital expenditures totaled 7.3% of net revenues, consistent with last year. This careful management of both the top and bottom lines delivered $44.7 million in free cash flows during 2010, a 38% increase over last year.

So in summary, 2010 was another very successful year for Shutterfly despite the continuing economic challenges. We significantly strengthened our product and services offerings and the connections with our customers.

We have maintained our strategic focus, gained new insights into our business drivers and demonstrated the strength of our value proposition in tough economic times. And finally, we continue to deliver on our commitment to increase profitability and free cash flows.

To complete my discussion, I would now like to summarize our outlook for Q1 and the full year 2011, together with some insight into our underling assumptions. Consistent with our historical trends, at the end of the Q4 holiday shopping period and continuing through this week, we have seen normal, seasonal patterns in our site traffic and order volumes.

However, while Q1 quarter to date growth rates are consistent with the trends we’ve seen in recent quarters, the significant growth rate comparison in 2010 could make it more difficult to maintain equivalent revenue growth rates in 2011.

In terms of the components of net revenues, we expect to see continued improvement in non-holiday growth rates, with more elevated increases around the traditional holiday and gift giving periods. We expect a consistent mix of revenues between new and existing customers with modest growth in average order 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 prints initiatives, we continue to make steady progress with a number of new customers, including those customers obtained through our WMSG acquisition. While still in the early business development phase, we believe that 2011 commercial print revenues will likely range from $8 to $10 million and have included this range in today’s financial guidance.

In terms of our cost structure for 2011, we remain firmly committed to our plan of increasing profitability and free cash flows, and will continue our strategy of carefully balancing strategic investments for growth with the requirement for increased profitability.

With the recent trends of improving business performance, we believe it is important to continue and expand on a number of new technology initiatives that we believe will both increase the rate of innovation in our product and services offerings, as well as significantly improve our long-term operating efficiency.

The nature of these investments include enhanced image rendering architecture, a proprietary tiered storage environment, CRM and other marketing and analytical systems and a number of major customer facing applications scheduled for release in 2011 and 2012.

As a leader in the markets for online personalized print on demand products and services, we believe that rapid product innovation and steadily leveraging the benefits from scale will create the greatest long-term differentiation from our competitors. With these comments as context, I’ll now summarize our initial guidance for Q1 and the full year 2011 starting with Q1.

We expect net revenues to range from $52 to $53 million, which reflects year-over-year growth of up to 16% and up to 22% excluding referral fees. We expect our GAAP gross margin to range from 47% to 48% of net revenues and our GAAP operating loss to range from $13 million to $12 million.

We expect our adjusted EBITDA will range between a loss of $2 million and a loss of $1 million, and that our GAAP effective tax rate will range between 33% and 37%. The year-on-year decline in Q1 adjusted EBITDA, reflects the fact that Q1 2010 benefited from referral fees and from the last installment from active IT licensing arrangements, combined with WMSG integration costs that are expected to be incurred in Q1 of this year. And finally, we expect the GAAP net loss per share to range from a loss of $0.30 to a loss of $0.26, based on approximately 28.3 million weighted average common shares.

Turning now to the full year 2011, we estimate that net revenues will total between $363 million and $373 million, reflecting year-over-year increases, ranging from 18% to 21% and 19% to 22% excluding referral fees. We expect the full year GAAP gross margin to range from 56% to 57% of net revenues, excluding referral fees, this guidance represents a gross margin improvement of up to 100 basis points over 2010.

We expect that our GAAP operating income will range from approximately $35 million to $40 million and that our full year 2011 adjusted EBITDA margin will range from 21% to 22% of net revenues.

Excluding referral fees, this guidance reflects an improvement of up to 75 basis points in our adjusted EBITDA profitability. The full year GAAP effective tax rate is expected to range from 33% to 37%. Also at the end of December 2010, we have substantially utilized our federal net operating loss carry forwards. As a result, we expect to accrue taxes payable for federal purposes during 2011 and we will begin remitting cash taxes beginning in 2012.

We continue to maintain net operating loss carry-forwards for California purposes and do not expect to generate any significant California cash liabilities during 2011. We expect full year GAAP net income per share to range from $0.74 to $0.81 per share, based on 31.3 million weighted average diluted shares.

And finally, we expect that 2011 capital expenditures will range from 7.5% to 8.5% of net revenues. This range includes approximately $2.1 million for landlord funded tenant improvements for our Redwood City headquarters, and up to $4 million in incremental capitalized R&D costs associated with the technology investments described earlier. Excluding these amounts, we expect capital expenditures associated with technology and manufacturing equipment to remain essentially flat as a percent of revenues with 2010 levels.

So, in summary, we believe that our initial Q1 and full year 2011 net revenue and profitability guidance gives appropriate weight to our most recent business performance, the current and anticipated market conditions and to this early point in our annual business cycle.

So, with that, I sincerely 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

Thank you. (Operator Instructions) Our first questioner in queue is Jim Friedland with Cowen and Company. Your line is open.

Jim Friedland – Cowen and Company

Great. Thanks. One of the things that I wanted to address was R&D. You guys have talked about some projects you’re working on this year and if you look at your incremental spend in 2010, it actually was fairly low and it looked like some of it moved down to capitalized development, and in terms of some of the new investments, should we think about an acceleration this year or should this continuation of more than even split between capped R&D, and actually I’ll stop there and maybe get back in the queue? Thanks.

Mark Rubash

Hi Jim. Certainly on the second deadline, a couple of things, one, you’re right. The total dollars on the P&L look relatively flat. There was about a $3 to $3.5 million increment in capped R&D during 2010. We were working to hire a number of additional engineers on top of the 30 or so that we did in 2010, so we expect that trend will continue into 2011.

The other thing to keep in mind is that the technology spend for hardware and software, particularly in the storage area has been coming down pretty significantly over the past few years. So we’re seeing year-on-year declines in depreciation expense. That is also rolling through the second dead line.

But we’re going to continue investments in some ever these fairly large projects that are both infrastructure and customer facing and that will continue through 2011 and into 2012, and a fair amount of that investment will get capitalized.

Jim Friedland – Cowen and Company

Okay. And then in general, should we think about the growth of R&D over the longer term to be roughly in line with revenues and sort as part of that question, because you guys are delivering stronger growth would you consider reinvesting at a more aggressive pace to further extend the lead? Thanks.

Mark Rubash

I think on the second deadline over the intermediate or longer term we’ll actually see some leverage there. A lot of what we are undertaking right now are things that are not one-time but they’re not every year types of infrastructure build, like the shared storage architecture, that’s going to serve us well and bring cost leverage for a number of years into the future.

So I think over the intermediate term, three to five years we’ll start seeing some leverage in the total spend. And in reality with the greater adoption of our PPS products, sales and marketing actually becomes more important as you go further in the mainstream consumers. So we think we start increasing on the sales and marketing and getting a little bit of leverage on tech and dev.

Jim Friedland – Cowen and Company

Okay. Great. Thanks a lot.

Operator

Thank you. Our next question in queue is Youssef Squali with Jeffries & Company. Please go ahead.

Youssef Squali – Jeffries & Company

Thank you very much. This is Youssef Squali at Jefferies. Two quick questions please. First, Mark, how much EBITDA in Q1 of 2010 was actually from the referral fees and other non-recurring sources? I’m just trying to kind of clean the last year’s numbers to see what the apple-to-apple comparison is, because you have historically have been trying to maintain positive EBITDA throughout the year and the last couple of years you were very successful in doing that. A little surprised to see you dipping back into that?

And then for Jeff, you obviously had a great business model, but international remains really a gaping hole in it. Can you speak as to why you have not been more aggressive in pursuing it and what would change your mind?

Mark Rubash

Sure. In Q1 of last year there were two discrete items that are showing up in the year-over-year comparison this year. One was, Q1 was the last quarter of referral fee revenue, it was also the last installment of active IT licensing arrangements at the time.

The aggregate of those two items was about $4 million of EBITDA impact, that was in Q1 of 2010, that is not recurring in 2011. Outside of that, the cost structure is pretty comparable to where we were last year at this time.

Jeff Housenbold

As to your second question, Youssef, about international, we still are very excited about the future of where we’ll be a global company. I think why we haven’t gone that direction primarily has been the opportunity here in the United States has been so vast. We’re still so early in these markets that have been transformed by variable print on demand and by consumers desire to personalize many aspects of their life in this entire new social networking kind of phenomenon, where people want to share more and more of life’s moments.

And so, we’re building the company quickly and investing in infrastructure that will make us a more successful global company when we do move international. I think the second reason that it slowed down those activities was the global recession and the pullback in Europe and across Asia. We will get there, it’s on the roadmap, but the decay rate is relatively slow. So we’re not moving much opportunity and we’re building the people, process and technology internally to ensure that we are successful when we do make that decision.

Youssef Squali – Jeffries & Company

Okay. Thanks a lot.

Operator

Thank you, sir. Our next questioner in queue is from Shawn Milne with Janney Capital Markets. Your questions please.

Shawn Milne – Janney Capital Markets

Thanks. Good afternoon and congratulations on the quarter. I just wanted to follow-up on the last question on the international side. Jeff, you just mentioned the technology you’re building out has global functionality. Is the likely to pass new commerce platform, is that being built to scale globally?

And then, if you just look out maybe you can give us a little bit more color on some of the new products that are coming in PP&S, clearly we’re continuing to see the adoption there and the growth remains strong. What should we look for in terms of size and scope, and timing on the new products in 2011? Thanks.

Jeff Housenbold

Okay. If you look the internationalization about our technology and platform cuts across the entire stack, so it is part and parts of our e-commerce platform is the cart and the ability to take multiple currency. It’s the ERP and financial systems to be able to handle that from a accounting standpoint. It’s our rendering capabilities that will allow that will buy characters and other imagery. It’s a content platform that allows to you source creative designs from around the world. So there are many aspects of the platform that we’re modernizing and building for scale.

As it relates to new innovations in PP&S, we won’t give specifics today, we’ll wait until we actually roll those out but we are working on step function changes in the way that consumers will be able to make photo books and tell their stories in a very dynamic, and very flexible and powerful way, while combining and using technology to help them do that I can request and easier. So we’re very, very excited about the advancements that we’re going to launch in the first half of this year on the photo book side.

And then in terms of cards and stationery and wall décor, we’re going to continue to expand the product breadth and the design assortment and the ability to easily search and find that exact perfect card for the sentiment and occasion that you’re looking for.

We think these two markets in and of themselves, the stationery market is $7 to $7.5 billion, greeting cards is $8 to $8.5 billion, and then photo books and photo albums and scrapbooking is another $6 billion. Those two markets are enormous and less than 2% is happening online today, and so we’re very excited about the tailwinds from the adoption rate and from now on our market leadership.

Shawn Milne – Janney Capital Markets

Okay. Thank you very much.

Operator

Thank you, sir. Our next question in queue is Mitch Bartlett with Craig-Hallum. Your line is now open.

Mitch Bartlett – Craig-Hallum

Hi. Good afternoon. The last question, I’ll just push it a little bit further. You talked about the photo book platform. The word platform catches my attention. You’ve been pushing kind of technology out to where the photos are with Simple Path. Does this extend that ability, is there some way enable you to engage on the social networking crowd in a better way?

And then the second question would be the Share Sites that you talked about, youth and the classroom and baby and wedding, and all of the progress there. But you didn’t really quantify it, was that a successful growth in the total number of group Share Sites over the last year?

Jeff Housenbold

Okay. So Mitch, I won’t give too much detail on the new photo book platform for competitive reasons. But if you think about our Simple Path platform and our Custom Path platform, they’re actually two distinct platforms.

What we’re working on is bringing those together in one platform that allows progressive discovery by our customers, so that they can make photo books by themselves or all the way to have us do that and be able to access their pictures universally, be it on their hard drive, on their Shutterfly Share Site, on their Shutterfly account, on Flickr, on Picasa, anywhere their images are on their iPhone and to be able to aggregate all of that media they have in various devices and various locations and bring them together in a very simple yet design forward way to tell their story. So we think it is a step function change from what the industry has and what our competitors have and we think consumers are going to be very receptive to the new platform.

In terms of Share Sites, we were very pleased with the continued growth during the fourth quarter, the number of group Share Sites continued to grow. Certainly, our dedicated and focused activities around youth sports and classrooms drives a lot of group activities and you get leverage in the registration and customer acquisition model there. And it gives us a direct relationship with potentially new customers to be able to talk to them about our products, build awareness, trial and then hopefully turn them into valuable and profitable customers.

Mark Rubash

And one thing I’d also add on Share Sites, Mitch, is that, I think there are some trends that are developing in terms of the utilization of the sites. We’re starting to see a pattern develop where the late summer, early fall months, whether that’s a combination of weddings and summer vacation activities and youth sports.

We’re seeing a natural increase in activity during that period of time, which actually feeds in quite well into our traditional holiday shopping period. So, I think, the multiple occasions and development of all of these verticals and the timing of how their patterns are shaping is going to bode well for us going forward.

Mitch Bartlett – Craig-Hallum

Great. Thank you.

Operator

Thank you, sir. Our next questioner in queue is Colin Sebastian with Lazard. Your questions, please.

Colin Sebastian – Lazard

Hi there. Thanks for taking my questions. I guess, just looking back for a second. I’m curious on your perspective given the product innovations and the growth that you’re seeing. Do you think that’s, are you seeing any acceleration in the shift of customers from some of your competitors, are you taking market share or is this broader growth in the overall category. And perhaps related to that in terms of the commercial environment, I think implied by your margins and by modest growth and average order value that you’re not expecting any meaningful increase in the competitive commercial activity in the coming year? Thanks.

Jeff Housenbold

Great. Based upon our channel checks and qualitative research, we do believe we’re taking meaningful share from our competitors, as they’re not singularly focused on the customer or the market and they haven’t invested the amount of R&D that we have in driving new products and making it easier for people to interact with their memories.

So we think we’re taking shares, as well as on boarding new entrance into the category very successfully, 2010 a large part of our success was driven by acquiring new customers, whose average order value was higher than our traditional installed base of customers and that’s a trend that bodes well for the future.

In terms of promotional activity, I think, with the back drop of a continued soft economic market place, I think competitors across the entire retail and consumer discretionary landscape are going to continue to try to get people into the store, if you will. I think we managed through that very well in ‘08 and ‘09 and 2010, and we’re very ROI and fact based and balancing our hard advertising dollars with our discounts and our promotions, which drove the upside in revenue for the fourth quarter and also increasing free cash flow.

So we’re not, I think, the guidance and Mark’s comments about the economic backdrop, indicate that we believe that things will be more similar to 2010 and perhaps, a little bit of improving trends in consumer sentiment and perhaps in real economic terms.

Colin Sebastian – Lazard

Okay. Thanks very much.

Operator

Thank you, sir. Our next questioner in queue is Aaron Kessler with ThinkEquity. Please go ahead.

Aaron Kessler – ThinkEquity

Great. Couple of questions, guys. First on the print side and nice acceleration of 10%, any additional color on that? And also then on the sales and marketing spend going forward, should we expect kind of a higher, you’ve seen like nice leverage in the last couple years, should we expect that more to grow in line with revenues going forward here? Thank you.

Mark Rubash

Hi, Aaron. On the sales and marketing on the second part of the question, I think, yeah, we’ll probably increase modestly sales and marketing as a percent of revenue. One of the things we’ve been saying for quite some time is that marketing dollars work best when the consumer has a mind set to spend.

So kind of trying to gauge that very carefully and putting our hard marketing dollars in the periods of time and in and around the categories where there is a high consumer intent works best. And as long as we see the demand response to the marketing effort, we’ll keep pulling that and working to capture as many new customers into the category as we can. And could you repeat the first part of your question?

Aaron Kessler – ThinkEquity

Yeah. The first question was on the print acceleration of 10%?

Mark Rubash

Okay. Yeah. The main components, keep in mind, that in the print category is a selection of basically greeting cards. We call them photo cards, are printed using the silver halide technology and over the past couple of years we’ve been restructuring the designs and the quality of those items, and this year in Q4 they actually accelerated quite nicely.

So we’re still seeing kind of the consistent long-term trend in the decline of 4x6 prints, so we actually saw in Q4 of this year was an acceleration in the photo card revenue. You may have noticed in one of my, in the prepared remarks I aggregated the photo cards because the use occasion is the same as a greeting card. And when you put photo cards together with our traditional cards and stationery category and photo books, that combined category is now 65% of revenues and on a combined basis grew 40% this year.

Aaron Kessler – ThinkEquity

Great. Thank you.

Operator

Thank you, sir. (Operator Instructions) Our next question in queue is James Cakmak with Sidoti. Please go ahead.

James Cakmak – Sidoti

Hi. Good afternoon. Can you provide a little bit more insight on the WMSG deal and what your expectations are there? I know you guided to revenue of $8 to $10 million within the segment. But I guess just broader expectations and do you see other opportunities out there for acquisitions to add more scale to that business this year?

Jeff Housenbold

No. We’re still strong believers in the commercial opportunity, it’s just developed a little slower with the economic recession that we had and so, the sales cycles elongated from what we had originally planned going into this in 2010.

The second lesson that we learned in going out and talking to dozens of potential customers, is that they are looking for a more complete solution and deeper analytics about their marketing spend, and because we’re Shutterfly, a consumer company that does that very well on the consumer side, they are excited to work with us because of the ability to leverage that knowledge from a consumer side of the business into the commercial. But we didn’t have some of the systems and the technology and the analytical packages built into our commercial print initiative. And so we looked at a build versus buy and led us to the WMSG acquisition.

Along with the technology that WMSG had, they had a talented group of individuals who know the space and have a number of long standing deep relationships with well-known companies, but they didn’t have the manufacturing scale and the financial balance sheet to be able to optimize those opportunities in front of them. So we’re very, very pleased about the WMSG team coming to join us and helping to drive our commercial print initiative.

We’ll from time to time look for additional tuck-in acquisitions, some of those may be in the commercial print arena, but with WMSG and what we have here internally, we’re feeling pretty confident for 2011 that we have the right tools in place to be able to execute and that was a factor in taking the $5.1 million in 2010 to $8 to $10 million range for 2011.

James Cakmak – Sidoti

Got it. And on the social media front. You guys already have successful iPad apps or iPhone apps, iPod and but there has been a lot of noise lately with the photo sharing apps, hi-fi high profile, we see they are gaining a lot of traction. I guess, what are your thoughts on what kind of affect that’s going to have within the photo sharing space? And do you see any opportunities to potentially partner, create a competing app or acquire any of these entities?

Jeff Housenbold

Yeah. I think we are very pleased about our breadth of sharing services that range across the iPhone, the iPad, our Wink service, our Shutterfly Share Sites and the ability to share a la carte via email through the Shutterfly platform.

We in the 11 years that we have pioneered and led this business that through many, many start-ups, back sized well-known VPS come and go, many in the sharing or feature functionality kind of arena, that are interesting and hot, but don’t have necessarily a robust monetization scheme or business model. So we’re very careful as we look at what generates buzz in tech crunch versus what rings the cash register and drives shareholder value in the long-term.

I think there is an opportunity because we own manufacturing and because we’re the leader in innovation, design and quality to partner with some of these companies, to help them monetize their customer base and extend the Shutterfly brand to new entrants into the category. So we’ll do a combination of build ourselves, as well as partner in the marketplace.

James Cakmak – Sidoti

Okay. Thank you.

Operator

Thank you. We have time for one final questioner and it comes from Heath Terry with Canaccord. Your line is open.

Heath Terry – Canaccord

Great. Thanks. Can you quantify what kind of traction you’re seeing in your mobile applications, what percentage of your members have downloaded them and what usage is like for those companies? And then ultimately is there a monetization model that you see for those apps, besides just kind of driving more engagement?

Jeff Housenbold

So, Heath, we’re not prepared to give the detail on usage metrics in mobile specifically, mostly for competitive reasons. But I’ll talk a little bit about the philosophy of how we think about mobile. We are very agnostic to device, to capture device. So if you take it with a digital SLR, a point and shoot or your smartphone, we’re agnostic as to what platform you are running on, a PC Windows based or Mac based. We’re agnostic to where your photos reside being on Shutterfly, your hard drive or on other photo sharing or photo storage companies.

What we want to do is provide you indicative solution that works for our customers wherever they are, whatever device they have and wherever their pictures reside, and we want to make sure that we’re open in terms of a platform to allow people to share those pictures out onto their blog, onto their Facebook account, to their Shutterfly Share Site, onto other social networks.

And so, if we could continue to lead this industry in terms of innovative products that people want to take their credit card out and we provide services like mobile, we think the overall business model helps us monetize the investments we make in mobile, where standalone companies will be hard pressed to figure out a business model in that arena, that’s all of the value chain that they offer.

Mark Rubash

I think one thing I’d also add is whether it is the iPad or one of the Android products that are coming out, I think we’re still at least a generation away or next rev away in terms of processing power for creation on those apps. I think it will happen but I don’t think it’s likely this year in any significant way and monetization, I think really follows the ability to create compelling products.

Heath Terry – Canaccord

And correct me if I’m wrong, but right now the, because, the existing generation of apps really only allows for upload to Shutterfly, given the competitive environment and how many of the apps that are out there now, are already kind of integrated into Facebook or into Twitter.

Is that something that you think fits in strategically with what you are trying to do and to the extent that you can talk about a timeframe for the next generation or the next upgrade of those apps, I’d appreciate it?

Jeff Housenbold

Yeah. So our philosophy our apps are already integrated into social media and we have been a leader and innovator in doing some interesting things with Facebook Connect and helping people manage some of the photos on their devices natively.

So if you think about where the pockets of monetization are, it’s really on the output side and it’s on the premium services to areas where we think we lead. So we’ll continue to listen to our customers of what they are demanding and what we believe they are willing to pay for it and we’ll put our R&D dollars into that space versus chasing the next cool feature functionality that won’t generate shareholder returns.

In terms of next generation, everyone is moving fast and furious into the tablet and the smartphone space. Lots of dollars are flowing from both the hardware and the services companies and we’re in constant contact with all of the right players, so that we’re thinking about how do we bring Shutterfly to more and more devices, and make it more and more indicative for our customers, but no specific timeframe on when that would happen.

Heath Terry – Canaccord

Great. Thank you.

Jeff Housenbold

You’re welcome.

Operator

Thank you, sir. This concludes our time for Q&A. I’d like to turn the program back over to Jeff Housenbold for any closing remarks.

Jeff Housenbold

Okay. I want to thank everyone for joining us on the call today and I want to thank all the 600 plus employees at Shutterfly for a fantastic 2010 across the entire organization. We’ve really fired on all cylinders, investments we made in ‘08 and ‘09 during the downturn as the markets started to pick up proved to be correct and we have a tailwind behind us, and a very exciting lineup of products and services and integrated marketing campaigns for 2011. Our guidance today reflects increasing momentum in the business and I think as we continue to play on these very large trends of social networking, on software as a service, on personalization and on offline to online, and retail to e-commerce, I think Shutterfly will continue to do well during 2011 and beyond. So we look forward to updating you on our Q1 progress in a couple of months and we’ll see you guys out on the road. Thank you.

Operator

Thank you, sir. Ladies and gentlemen, this does conclude today’s program. Thank you for your participation and have a wonderful day. Attendees, you may now disconnect.

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