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Shutterfly (NASDAQ:SFLY)

Q3 2011 Earnings Call

October 26, 2011 5:00 pm ET

Executives

Michael Look - Vice President of Investor Relations

Jeffrey Housenbold - Chief Executive Officer, President and Director

Mark J. Rubash - Chief Financial Officer, Principal Accounting Officer, Senior Vice President and Secretary

Analysts

Mark May - Barclays Capital, Research Division

James H. Friedland - Cowen and Company, LLC, Research Division

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

Mitch Barlett - Craig-Hallum Capital Group LLC, Research Division

Youssef H. Squali - Jefferies & Company, Inc., Research Division

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

Operator

Good day, ladies and gentlemen, and welcome to Shutterfly's Third Quarter 2011 Financial Results Conference Call. [Operator Instructions] As a reminder, this conference call may be recorded. I would now like to turn the conference over to Mr. Michael Look, Vice President of Investor Relations. Sir, you may begin.

Michael Look

Thank you, operator. Good afternoon, everyone, and welcome to our call today. With us on the call are Jeff Housenbold, Chief Executive Officer of Shutterfly; and Mark Rubash, Chief Financial Officer. The press release detailing our results is available on shutterfly.com and archived copy will be kept on our website as well. We have also posted some slides that we will use as we go through this call. Additionally, within a few hours, we will release a recording on this call, both in a streamed online format and through our 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 Private Securities Litigation Reform Act of 1995. These forward-looking statements include statements related to our business outlook and strategy and statements about historical results that may suggest trends for our business.

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

I'd also like to note today that any forward-looking statements made on this call reflect our analysis as of today. This presentation contains certain financial performance measures that are different from financial measures calculated in accordance with GAAP and may differ from calculations and 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 third quarter 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?

Jeffrey Housenbold

Thanks, Mike, and welcome, everyone, to our third quarter 2011 earnings call. I'll start today's discussion with some thoughts on our year-to-date performance and a review of our Q3 high-level results, followed by an update on our Tiny Prints integration, and our key focus areas as we head into the Q4 holiday season. Following my prepared remarks, I will turn the call over to Mark, who will review our third quarter financials in detail, and provide updated guidance for Q4 and full-year 2011. We'll then open up the call for questions.

As you listen to our remarks today, I'd like you to keep in mind 2 key messages. The first is that investments in our product and service offerings, platform infrastructure and people throughout 2011 have positioned us well for the Q4 holiday shopping period. Our commitment to innovation, design for our products and services, customer-friendly policies, industry-leading quality and focused financial discipline, continue to differentiate Shutterfly from the competition.

It is that same focus and passion that brought Shutterfly and Tiny Prints together, combined our world-class online platform of Personalized Products & Services is enabling us to achieve our vision of making the world a better place by helping people share life's joy.

Second, we believe that we are best positioned to transform the multibillion-dollar social expression and personal publishing markets from offline and generic to online and dynamic and personalized content. With less than 5% of this market's commerce activity being conducted online, it is clear that we are still in the early stages of adoption, and are confident that online will continue to take share from offline.

The consumers' preference for a higher quality, personalized product at a fair price over static, generic content is a much stronger consumer value proposition. As a result, we will continue to make investments in key areas of our business. We believe these investments will enable us to enhance awareness; increase our customer base; increase revenues and extend our market leadership; accelerate the development of innovative and compelling products, services and user experiences, such as our award-winning line of Cards & Stationery products, and our all new Custom Path Photo Books experience; and help us achieve operational efficiencies that improve margin, increase shareholder value, and position as well for the future.

With these thoughts as backdrop, I'll now review our third quarter high-level financial results.

As you can see from our press release issued earlier today, Shutterfly reported top and bottom line results that were at or above the high end of our guidance ranges. These very solid results, which were driven by healthy customer metrics and revenue growth in each category of our business, clearly reflect our relentless commitment to satisfying every customer, and our ability to execute at the highest levels despite the fragile economic environment.

Q3 marked the 43rd consecutive quarter of year-over-year net revenue growth at total net revenues for the quarter, including Tiny Prints, grew 56% year-over-year to $76.5 million. Excluding Tiny Prints, total net revenues for the quarter were $60.5 million, up 24% from last year.

Net revenues from our core Shutterfly business, which excludes Commercial Print, grew 17% year-over-year, and continued to be driven by very solid growth in Personalized Products & Services. Also during the third quarter, Commercial Print revenues increased meaningfully to $3.9 million.

Looking at the top of our funnel, we continue to see healthy double-digit growth in key customer engagement metrics, such as visits, registrations and uploads and a record number of quarterly share sent. This activity translated into more than 1.5 million customers. We generated nearly 2.6 million orders across our 2 key brands.

Average order values at Shutterfly were essentially flat relative to last year. While at Tiny Prints, excluding one-to-one greeting cards, average order value grew 16% year-over-year. These are very solid results, when you factor in seasonal weakness, the challenging economic environment and the impact our planned optimization testing at Tiny Prints likely had on customer engagement.

I'd like to take a moment and talk about the optimization test that we conducted at Tiny Prints this past quarter. As we indicated on our last call, we are performing a number of tests to better understand the trade-off between growth and margin as we head into our seasonally strong fourth quarter. The areas that we evaluated, included price elasticity, promotion frequency and depth and marketing channel mix. As a result of these tests, we now have a better understanding of key optimization levers, and have already seen customer engagement metrics at Tiny Prints improve through the start of the Q4 holiday season.

Now I'll briefly update you on the status of the Tiny Prints integration. The integration continues to proceed smoothly and largely as expected. The teams continue to work well together and are well aligned. And while we continue to make significant progress in areas such as systems and process migration, along with 2012 planning, much of our third quarter focus has been on Q4 preparedness, especially in the area of manufacturing.

As part of our preparation for shifting roughly 60% of Tiny Prints' fourth quarter volumes from outsourced partners to in-house manufacturing, we started fulfilling a limited amount of Tiny Prints' third quarter volumes through our manufacturing facilities.

We also started making meaningful enhancements to both of our manufacturing facilities to accommodate the significant volume increase. These modifications included change in the layout of equipment on the floor to optimize workflow, installing additional digital presses to increase capacity and implementing automation technologies that we believe will improve overall quality, lower unit cost, increase throughput and lower variable spend. We are well into completing this process, with just a few more milestones to achieve before Q4's peak selling season.

During the quarter, we also began, on a limited basis, to cross sell select products between the Shutterfly and Tiny Prints' customer base. Our primary goal, once again, has been to ensure that our integration of Tiny Prints was as seamless as possible for our customers.

Finally, as we head into my seventh holiday season here at Shutterfly, and once again very enthusiastic about our prospects for Q4 and beyond, this year's lineup of products, services and user experiences is by far our strongest and most diverse to date.

Let me highlight just a few of the exciting enhancements that we have made to our world-class platform of Personalized Products & Services.

Starting with Photo Book. Our all new Custom Path continues to receive strong positive reviews and is quickly establishing itself as the industry’s leading Photo Book creation experience. We are also continuing to help consumers find more creative ways to preserve, tell and share their stories.

Earlier this month, we launched our new online Storytelling destination, focused on 3 key components of photo book creation; photography, storytelling and design. Our new Storytelling destination will offer readers fresh inspiration and tips each week. Whether it's sharing tips for taking great photos of your kids, suggesting innovative ways to caption your story or offering page layout advice from professional designers, Shutterfly customers will find help in telling their stories of special occasions and everyday moments.

And now, with 71 distinctive style kits to choose from, customers have everything they need to tell their story the way they want, with the quality, ease of use and variety of designs that they've come to expect from Shutterfly.

Moving on to Cards & Stationery. With our recent addition of Tiny Prints, our Cards & Stationery category now includes the best breadth and depth in designs and styles at multiple price points available online. Currently, customers can choose from more than 3,500 unique and exciting designs for their holiday correspondence, with more designs to come in the weeks ahead. We've also expanded our assortment of premium card features this year. They include printing on the back at no additional cost, back of card design and innovative new shapes, format and card treatments.

Lastly, we continue to make meaningful enhancements to our customers' shopping experience and merchandising capabilities. With the introduction of attribute-based navigation, customers are now able to optimize their search experience by highlighting the style, attributes they value most to quickly and easily find their perfect card.

We also continued to extend our calendar and photo merchandise category with new products and designs. During Q3, we introduced 11 new wall and desk calendar designs, offering more sophisticated looks, including illustrations in watercolor, as we leverage our combined Shutterfly and Tiny Prints design resources. We also introduced 5 new products during the third quarter, focused on mugs and home decor.

Moving on to our share sites. We ended the third quarter with 3.6 million share sites, and continued double-digit year-over-year growth in the number of shares sent. In particular, we saw strong site creation growth in our key target categories, including classrooms, as our classroom connections challenge marketing campaign delivered its desired effect; and in youth sports, where we were able to leverage our strong partnerships with organizations like AYSO, CalSouth, and California Youth Sports Association.

In summary, Q3 was another very successful quarter. We delivered solid growth in our core PP&S categories, saw a healthy customer behavior and made significant progress in our Tiny Prints integration. Clearly, we continue to distinguish ourselves from our competition.

And as we enter this year's holiday season, I believe that this is by far the strongest lineup of products, services and user experiences that we've had in the 7 years that I've been here at Shutterfly. So you can understand why I am pleased with our progress to date and so enthusiastic about this upcoming holiday season and our opportunities going forward.

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

Mark J. Rubash

Thanks, Jeff, and thank you, all, for joining our call today. I'll start this afternoon's discussion with some observations about our third quarter performance, followed by a review of our key metrics and operating results, and end with our updated Q4 and full-year 2011 outlook. Following my prepared remarks, we'll open the call for your questions.

Earlier today, we posted third quarter results that were at or above the high end of our guidance ranges for net revenues, adjusted EBITDA and net income. These results were largely driven by strong customer engagement metrics at Shutterfly and solid contributions from Personalized Products & Services and from Commercial Print.

For Shutterfly, customer engagement metrics remained healthy with double-digit growth in visits, registration, unique uploaders and uploaded images and a record number of shares sent. This activity translated into 1.4 million transacting customers who generated 2.4 million orders with an average order value of $23.71.

On a year-over-year basis, Shutterfly saw a 16% increase in customers, a 17% increase in order volume and average order value remained essentially flat with the prior year.

For Tiny Prints, Q3 is the most seasonally challenging quarter. The lack of card-based occasions and busy vacation schedules combined this year with our planned revenue optimization test, clearly impacted customer conversion metrics and revenue growth, so average order value remained very solid at $84.62 and $103.82, excluding one-to-one greeting cards.

As Jeff mentioned earlier, our optimization efforts focused on a number of factors, including pricing elasticity, promotion depth and frequency, paid search optimization and marketing channel mix. The goal of these programs was to evaluate optimal marketing approaches, not just for Q4 but for future periods as well. With much of the learning in hand, we're now starting to see notable improvements in Tiny Prints' customer metrics and the revenue growth in these early days of Q4.

Taking a more detailed look at our results. Quarterly net revenues totaled $76.5 million, a 56% increase over the prior year. Net revenues from Personalized Products & Services, increased 73% to $56.5 million. Print revenues increased 3% to $16.1 million. And Commercial Print contributed $3.9 million, a $3.3 million increase from Q3 of last year.

Excluding Commercial Print, net revenues from the core Shutterfly business grew 17% year-over-year, with 77% of Shutterfly core net revenues coming from existing customers and 23% from new customers.

For Tiny Prints, net revenues in the quarter totaled $16 million, reflecting 21% year-over-year growth.

In terms of overall product mix, Personalized Products & Services represented 74% of total net revenues. Total prints represented 21%, and Commercial Print revenues increased to 5%.

And finally, net revenues from 4x6 prints represented 12% of total net revenues.

Moving to cost of net revenues and gross margins. We reported a gross margin of 45.6% in Q3, which is at the midpoint of our guidance range and down from the 49.1% margin we reported last year. The year-over-year decrease in gross margin reflects a full quarter of Tiny Prints customer service and outsourced manufacturing cost, lower Photo Books ASPs, reflecting continued trial oriented promotions and an increased percentage of lower margin Commercial Print revenues.

Q3 gross margin also reflects certain manufacturing costs for Tiny Prints' capacity increases and automation equipment in front of the seasonally strong Q4. Notably, on a year-over-year basis, excluding the impact of Tiny Prints and Commercial Print, the core Shutterfly gross margin improved by approximately 120 basis points.

Turning now to operating expenses. Overall, excluding stock based compensation, operating expenses totaled $48 million, reflecting the combined Shutterfly, Tiny Prints full quarter cost structures, partially offset by various cost management efforts and decisions to reallocate certain advertising and promotion programs closer to the key Q4 holiday season.

Looking more specifically at our operating expense components, technology and development costs totaled $18 million from the quarter or 24% of net revenues, consistent with Q3 of last year.

Excluding stock based compensation and depreciation, our technology and development spending increased approximately $5 million or 60% from the prior year. The increase in technology and development spending reflects the addition of the Tiny Prints technology team, together with incremental investments in engineering headcount.

Sales and marketing expenses totaled $25 million in the quarter, representing 33% of net revenues compared to 23% in Q3 of 2010. The year-over-year increase reflects the addition of the Tiny Prints marketing team, partially offset by reduced advertising levels across the Tiny Prints brand.

Excluding stock based compensation and amortization, sales and marketing expense increased approximately $9 million from the prior year and represented 25% of net revenues.

General and administrative expenses for the quarter totaled $14 million or 19% of net revenues, relatively consistent with G&A as a percent of net revenues in Q3 of last year.

Excluding stock based compensation and credit card processing fees, G&A expenses represented 11% of quarterly net revenues, consistent with the prior year.

Adjusted EBITDA for the quarter was a loss of $3.3 million, significantly better than our most recent guidance, which projected an EBITDA loss of $6 million to $7 million. This favorable EBITDA performance was driven largely by solid revenue growth combined with overall cost management.

The effective tax rate for the quarter was 56%, primarily reflecting in-quarter tax benefits from incentive stock options and R&D tax credits.

On a GAAP basis, our net loss for the quarter totaled $10 million or a loss of $0.29 per share, an improvement over our previous guidance. The weighted average shares used to calculate the net loss per share totaled $34.6 million.

And finally, capital expenditures during the quarter totaled $12.1 million, including $4.6 million for technology equipment and software, $4.7 million for manufacturing equipment and building improvements and $2.8 million in capitalized research and development.

Cash and liquid investments at quarter end totaled $68.7 million.

To complete my discussion today, I'd now like to summarize our outlook for the fourth quarter and the full year 2011, and share some insight on our underlying assumptions. Over the first 9 months of this year, we have grown our customer base, strengthened our market position and expanded and enriched our product and services offerings. We've also added new designs, styles and formats in both our cards and stationery and photo book product lines and introduced many new technologies, including our all new Custom Path for Photo Books and site-wide attribution-based navigation.

As a result, we continue to see strong demand across the Shutterfly, Tiny Prints and Wedding Paper Divas brands, and believe we are leading the transition from offline to online in the social expression and personal publishing markets.

In short, with a solid customer base and differentiated product lineup, we remain enthusiastic about our core growth markets as we approach the all-important holiday season.

Even with an industry leading value proposition, as a consumer facing business, we are also mindful of the current state of the U.S. economy and the impact of various external factors may have on consumer discretionary spending, including persistently high unemployment rates, historically low consumer sentiments and the highly volatile financial markets. Given the potential dampening effects of these factors could have on holiday spending, we believe that our thoughtful assessment of our Q4 and full year 2011 outlook is warranted.

As a result, we have decided to leave our previous full year net revenue guidance largely intact, but have narrowed the range by raising the low end by $5 million. A key factor in support of this modest guidance improvement is that historically, we have seen a high correlation between current year Q4 revenues and the number of repeat customers from the prior year and from customers who transact in the first 3 quarters of the current year.

Given the strength of our Q4 business last year combined with our solid performance in the first 9 months of 2011, we expect this positive correlation to remain for this year's holiday season.

In terms of cost structure for Q4, we continue to balance our investments for growth with our commitment to increase profitability and free cash flow. Specifically, we'll continue our efforts on a number of important technology initiatives, focused on longer term efficiency, such as our manufacturing automation projects, which we believe will help offset the increased cost structure associated with the Tiny Prints acquisition.

In addition, we expect to continue our historical Q4 marketing activities, including extensive online and offline programs, and our first-ever direct response television advertising, focused on our award-winning line of photo books. We're excited about the prospects that DRTV could have on building category and brand awareness, and look forward to sharing our observations with you during our next call.

With these points as a backdrop, I'll now summarize our revised financial guidance starting with Q4. We expect net revenues to range from $270.5 million to $275.5 million, reflecting year-over-year growth of up to 66%. We expect our GAAP gross margin to range from 59.4% to 61.1% of net revenues, and our GAAP operating income to range between $77.2 million and $82.2 million. We expect our adjusted EBITDA will range from approximately $96.3 million to $101.1 million. And that our GAAP effective tax rate will range between 50% and 55%. We expect the GAAP net income per share will range from $0.98 to $1.03, based on approximately 37.6 million weighted average diluted shares.

Turning now to the full year 2011. We now estimate that net revenues will total between $480 million and $485 million, reflecting year-over-year growth of up to 58%. We expect the full year GAAP gross margin to range from 54% to 55% of net revenues. We expect that our GAAP operating income will range from approximately $20 million to $25 million, and that our full-year 2011 adjusted EBITDA margin will now range from 18.9% to 19.7% of net revenues.

The full year GAAP effective tax rate is expected to range from 25% to 35%. We expect the full year GAAP net income per share to range from $0.42 to $0.46, based on approximately 35.4 million weighted average diluted shares.

And finally, we continue to expect that 2011 capital expenditures will range from 7% to 7.5% of net revenues. This range includes approximately $2.1 million for landlord funded tenant improvements, and up to $10.9 million in capitalized R&D cost.

In summary, we are pleased with our third quarter and year-to-date results and remain confident of our market position and product offerings, as we head into the all-important holiday season.

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

[Operator Instructions] Mr. Squali.

Youssef H. Squali - Jefferies & Company, Inc., Research Division

A couple of questions, starting with you, Mark. On Tiny Prints, can you just go back and kind of expand on the slower growth? I think you said $16 million in price, about the 21% year-over-year growth. That's the material deceleration from the growth rate the company was on when you acquired it. I think last year I think it is something north of 50%. So what's going on there? And then maybe you can just also quantify the impact of Tiny Print on gross margin this quarter. And then, Jeff, TV is brand new for you. I was wondering what kind of -- what made you decide to go that route? What kind of gives you the confidence that the ROI on that will actually be in your favor?

Mark J. Rubash

So on the growth factor, if you go back to the time of acquisition, one of the things we said we are going to do was take a hard look at their marketing approach, particularly in comparison to where Shutterfly had been historically. And the goal of really trying to understand where are there opportunities from pricing, from promotion, from different channels of marketing and so forth. And Q3 was really, I think, our best opportunity to test a number of different optimization approaches for Tiny Prints. One is, historically, Q3 is the weakest quarter, slowest growth and historically has been the lowest revenue quarter. That's driven by combination of summer vacations scheduled, but also there really are no greeting card occasions in Q3. So it gives you a very effective base line. So as you saw, there's a pretty meaningful 16% increase in the average order value. We saw that effectively across both Tiny Prints and Wedding Paper Divas. Wedding Paper Divas was the stronger of the 2 brands in the quarter just because by nature, it is occasion-based. If it's very special occasion, there's less price sensitivity. But in addition to testing different price points, we tried a number of different approaches in terms of frequency of promotion. We really pulled back pretty meaningfully, particularly in the first part of the quarter. We did a lot of work in testing in the amount of spend, particularly in paid search and affiliates. The combination of those things, I think came together, really reflecting on a slower growth rate. Having said that, we learned an awful lot about where the optimization points are in pricing. We learned a lot about what can be done on occasion-based pricing, frequency of promotion and paid search as we go into Q4. And as I described on my prepared remarks, even in the early days of Q4, we're already seeing meaningfully higher growth rates in terms of orders and revenue across both of the Tiny Prints brands. So I think maybe we pulled the levers a little bit hard, but I think, really trying to understand what the base line opportunity there, was important as we try to differentiate across the brand. In terms of the gross margin question, I think the rough number is probably about 1 percentage point of gross margin attributed to Tiny Prints this quarter, and roughly an equal amount related to Commercial. As I said in the prepared remarks, if you exclude Commercial Prints, which has an inherently lower gross margin at these volume levels, and you exclude the Tiny Prints volumes, which were essentially all outsourced cost in Q3, the year-over-year core Shutterfly gross margin actually improved about 120 basis points.

Jeffrey Housenbold

Yes, if I may add. To just add to Mark's, and then I'll answer your question on DRTV. The effect of all the testing that Mark spoke to drove average order value for Tiny Prints brands, up 16%. And so what we did was we raised prices, we reduced promotion and we targeted customers through different channels to test the price elasticity. And the aha was we have a pretty broad range of being able to now drive margin or drive revenue. And that information allowed us to get the fuel mixture right as we head into the fourth quarter now that we understand that brand and its interaction as it relates to Shutterfly and the marketplace. So the testing was very valuable as we head into the fourth quarter. On DRTV, you asked, what gives me confidence that it's going to work. I think we've done some careful studies here. We looked at other companies that are Internet and e-commerce that are doing television in different fashion. And that led us to have enough confidence to go out and test DRTV in the fourth quarter. It's a sub-million dollar test. It'll collect actual data. If it works, we'll put more money behind it. If it doesn't work after we tweak it, then we'll look for other channels. The strategic intent behind it is we want to continue to grow the top of the funnel awareness, given that we're in the earliest days of addressing these multibillion-dollar markets. And they're still primarily offline, and trying to build that awareness and trial. And television is an effective mass medium to reach a broader audience. So we'll see how it works as a standalone. We'll see how it works as part of an overall integrated marketing campaign, and we'll come back in Q1 and share with you some of the data and what it implies for our marketing strategy in 2012.

Operator

Our next question comes from Shawn Milne from Janney Capital Market.

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

Just want to -- if I did the math right, Mark, it looks like the Shutterfly core PP&S business was up about 25%. Was there any testing going on there in the quarter? That's a pretty material deceleration. I know you had a tougher comp that included some large Groupon events last year. But was there anything in there related potentially to further shipping to -- that was cost maybe accounts for revenue. And then I have a question, a follow-up for Jeff on the TV.

Mark J. Rubash

Yes. On the Shutterfly side, I would say we followed a pretty consistent approach overall in terms of the channels we're in, the frequency and the depth of different promotions. The one place, I think, that was meaningfully different, last year in Q3, we actually had 2 very large Photo Books promotions. One was to our installed base, which was very meaningful; the other, which was our very first Groupon, and one of the first national Groupon campaigns. So both of those had a meaningful impact on Q3 revenues and Q3 unit volumes in Photo Books. This year, we're much, much lighter with respect to Groupon and that channel in general. We also were more selective, try to be more targeted with promotions in Photo Books in the core installed base. So we opted to be less promotional intensive relative to those 2 comps in Q3. Absent those, I think it was a pretty solid quarter overall across the product mix.

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

Wouldn't we have seen, if you were lighter on those promotions, wouldn't we have seen AOV actually go up, though?

Mark J. Rubash

Not necessarily, it depends on it. It's the incremental dollar of revenue that you get by going very, very deep to a large base. So ASPs overall on Photo Book were a little bit lighter year-over-year, part of that is due to mix, part of that is just due to the different promotion that we did do.

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

Okay then. Great. Just kind of looking at your guidance for Q4, and you're assuming an acceleration. Part of that is you obviously explained with Tiny Prints, but are you thinking that your Shutterfly core PP&S also accelerates in Q4 as the comp gets a little bit easier?

Mark J. Rubash

I think more, just because of all the activity that historically has occurred in Q4. Greeting cards will by far be the largest set of SKUs across the whole brands, followed by Photo Books and then calendars. But it is a seasonally strong time of the year, and the broadest product lineup that we've had, plus we think we're going to have a solid performance across the brands in Q4.

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

Okay. And then, Jeff, we've all -- you're probably one of the calls we've watched, some other e-commerce companies do TV, and some are more successful than others. This company, are you seeing you have more wind at your back from large audiences, like obviously Facebook. I'm just wondering what -- as you strategically look at your opportunities to add more on the top of the funnel, why can't -- I realize it's just a test, but the thought process around that versus maybe spending a little bit more on social media?

Jeffrey Housenbold

We're actually spending more across all of the channels on a year-over-year basis from a discrete dollar amount. And now, it's about getting the right fuel mixture in different parts of the consideration funnel, so awareness, consideration, trial, repeat. So we lined up what are the effective channels against each one of those steps in the funnel. So Google is great for driving conversion. It's not great for awareness, right? Because you have to come in and say, "I'm looking for birth announcement." And so it's more of a directed sale. When we go out and we look at what our awareness rates are and what are the barriers to usage, and what's our true competition, it's not other online players. It's your retailers, your pharmacies, your big box retailer and changing consumer behavior. And so when we lined up what's an effective way, DRTV, which is different than national broadcast just branded, right? We're going out with a very directed message, with an offer in spot cable against our targeted demographic with CPMs that are quite reasonable, given other alternatives for those dollars. And so when we looked at it, it's an effective tool. It's not the only told. It's not going to be a silver bullet. But it's an effective -- it has the potential to be an effective tool in the overall integrated marketing arsenal.

Operator

Our next question comes from Colin Sebastian from Robert W. Baird.

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

I just have a couple of questions. First off, I wonder if you could shed any more light, Jeff, on maybe plans for a single card sales on the Shutterfly side. Is that something you might start to experiment with here in Q4? I know you've done some tests on Tiny Prints. And how much that could impact spending and margins looking ahead till next year? And I have one follow-up.

Jeffrey Housenbold

So as far as single card sales, Q4 is really a multi-card sales quarter, right? People are sending dozens to hundreds of holiday cards for Hanukkah and for Christmas. So it's really a focus, one-to-many card opportunity versus a one-to-one opportunity. So on the core Shutterfly site, we're going to focus there instead of diluting the attention. We're going to continue to incubate our one-to-one greetings offering on the Tiny Prints website throughout Q4, and continue to test, refine, add more features and functionality. And I think that will tee us up for some interesting results and interesting efforts as we head into 2012 around the one-to-one card strategy.

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

Okay. And my follow-up is with regards to some of your competitors, Kodak and HP undergoing a number of changes. Does that change your perspective on the competition? Or it provides you potentially with opportunities?

Jeffrey Housenbold

Yes. In the overall competitive landscape, if you look what has made of the clear leader and winner in this space over the last 11 years, I think it's been singular focus on this category, understanding the customer better, innovating, being designed forward, having high quality throughout the entire customer experience and throughout physical products. And that focus has allowed us to go from pioneering a small company to being the clear leader today. And as our competitors, be it Kodak or Wal-Mart or HP, their multi-business kind of broader companies that are focused fighting fights on many fronts. I think that just continues to benefit us as we focus on delighting our customers and attracting new customers into what we think is a much better value proposition where you can personalize, you can get better quality and you can do that at a lower price in the convenience of your home or your office. So we think it just benefits us as our competitors are distracted.

Operator

[

Operator Instructions] Our next question comes from Jim Friedland from Cowen and Company.

James H. Friedland - Cowen and Company, LLC, Research Division

I just wanted to ask you on the macro comments, Mark, as you've been talking about it since the recession. And it's -- I was just wondering if there's anything that you'd seen Q3, quarter-to-date and Q4 that looks really similar to when we were -- we went to the recession the last time, and in terms of the guidance, or is that just the continued caution here I guess would be the higher level of macro data is not good. And then, Jeff, the second question is on mobile strategy. Part of this on Android, you haven't launched an app yet. And now with Ice Cream Sandwich, when you give you tablet andphone, is there something you want to do there? And then on the iPhone, iPad side, with iOS, if you start adding content creation to the current app, will Apple -- will you be paying Apple by the 30% tax, as developers need to pay. And then any kind of insight on the mobile strategy would be great.

Mark J. Rubash

So on the macro, I think where we're at, with our assessment right now is by and large, consumers are probably not as well off today as they were this time last year. Whether you measure that by sentiment whether you measure that by wage income or just actual spending pattern. Having said that, I think there's still a fair amount of time before our business really gets into gear for the holiday season. Typically we don't see an inflection point until mid to late November. It's going back into some of our records from last year. And really we didn't start seeing any real outperformance versus our internal plans and up until Thanksgiving. So all of the over performance and the strong results in last year's Q4 really started the day after Thanksgiving. And I expect that pattern is going to be consistent this year, just like it has been in the past several years. Kind of putting that, the macro into context, I think it puts us in a position where there's a greater level of uncertainty of what the consumer might actually do in the Q4 holidays. I think they have the potential to spend at levels fairly consistent with last year. But whether they actually do, I think is going to have more to do with how comfortable they are with their own situation as we get closer into the holiday season.

James H. Friedland - Cowen and Company, LLC, Research Division

Okay. That's helpful. And on the mobile?

Jeffrey Housenbold

Sure, on mobile. We're very thoughtful about mobile and making sure that what we build has a good return on investment. So if you look across the mobile landscape, there's a thousand different applications on iTunes today around photo capture, photo edit, sending greeting cards, creating photo-based products, but depending on the device, the use case for targeted demographic, I'm not familiar with any of those that are making any real money. And so we think about what it is that our customers want today, and what is the right environment user experience for the right device. Because you don't want to just create a ubiquitous environment, put it across all devices, because I'm not going to sit there and make a Photo Book, while our customers on an iPhone, for example. Right? So we're being very thoughtful about prototyping and testing different applications before we launch them out into the marketplace. As far as Android, I think if they continue to get a meaningful share of the smartphone market, and as Google tends to be more friendly in terms of an open ecosystem. I think Android will be part of our solution, consistent with our strategy of working on all devices and all platforms. So today, Shutterfly is available on both a Microsoft and an Apple based operating system across desktop, mobile and tablets. And that's our strategy and goal. So I think you'll see us to continue to push across multiple operating systems. In terms of creation in apps and payments to Apple, I think Apple continues to refine their approach. I think they've been more focused on virtual goods companies. If they want to be able to track companies that sell hardgoods with real cost of goods sold, they're going to need to continue to modify and be flexible, if they want to encourage adoption of their ecosystem. So we are being thoughtful about what is the right user experience, what's the right economics and what does that mean for both the short-term and long-term health of the business and our shareholder returns.

James H. Friedland - Cowen and Company, LLC, Research Division

That sounds -- that's helpful. And on the -- and so it sounds like for smartphones, that's more about photo sharing and uploading, and for tablets larger screens, there is the potential for content creation there and yields. Now we can just extend your core business to more mobile devices, is that the way to think about it?

Jeffrey Housenbold

I think it is, but not just -- so yes, but you wouldn't want to just take the experience available in the browser and put it over to a tablet. I think you want to create specific experiences on specific products for that environment. And that's what we're working on.

Operator

And our final question for today comes from Mark May from Barclays.

Mark May - Barclays Capital, Research Division

First question on margins. Prior to Tiny Prints, the company had a fairly consistent cadence of recognizing cost leverage and margin expansion. Obviously, Tiny Prints had an impact on that. But it appears that your Q4 guidance advised that you'll be at or above pre-Tiny Prints margins less than 12 months after acquiring the business. And that seems to be based on only 60% of manufacturing being in-housed in Q4. So the question is, is it fair to say that from here going forward, kind of 12 months after Tiny Prints or less than of it, we should continue to see the kind of operating leverage that the business was seeing prior to Tiny Prints? And in fact that seems like you could even see at least sort of the few quarters here even a greater than historical average extension in margins. And then so I had one follow-up, please.

Mark J. Rubash

This is Mark. I think in general I would say that is the right way to think about it. But you also have to be careful about the changes in mix of the source of revenues over time. So with respect to Tiny Prints, in particular, which today is nearly 100% cards and stationery product line, this year in Q4, we'll do somewhere -- 16% maybe even more percent of their unit volumes internally. And that will have a meaningful margin improvement that will reflect in our EBITDA guidance. Last year, as I recall, they were about 2.5%, using a fully outsourced manufacturing model. As we go forward next year, we fully intend to bring additional percentage of their volume. So I don't think we'll ever get to 100%. Some of the more premium products, for example, Letterpress and other types of our set of printed cards are smaller in volume, much higher prices. We'll probably continue outsourcing those for the foreseeable future. But we will in-source a greater percentage next year. We'll also have the benefit from manufacturing of doing manufacturing for an entire year instead of just a partial year. On the flip side, this year, we did not absorb their first 4 months of EBITDA loss, because the acquisition closed in late April. So we'll be picking that up in the first part of next year. Although, we think it will be an improved cost structure. So the things that will have the potential to offset some of those leverage gains are going to be things like continued growth in the commercial business over the long term and higher volumes. We think we can get that to about 30% operating margins business, but it will have inherently lower gross margins, but it will be incremental gross margin dollars. Similarly in the very nascent one-to-one greeting cards part of the business, we think that is a meaningful opportunity going forward and in the early days, as we're building that, there'll be a lot of trial and other types of promotions to bring awareness to the category. So those will likely have lower margins on a single unit than a one-to-many order, for example, on a wedding. So understanding -- if you pay attention to the mix and the things that are building into the model, there'll be puts and takes but in the Cards & Stationery in particular, we think there will be meaningful leverage as we get to next year and beyond. And then across the company, I think the trend we've been seeing of kind of modest leverage in detecting deadlines, meaning those costs, I think, over the intermediate term will go slower than revenues. I think marketing will be an increasing investment as we work to build broader and broader awareness of the expanded set of products and brands. And G&A has been a continuing source of leverage, and we expect that trend to continue.

Mark May - Barclays Capital, Research Division

Okay. My last question is on acquisitions. My understanding was that, maybe over the summer, even predating that, that a lot of the attention internally was focused on looking at growth opportunities through acquisition in Europe and the U.K. But there's been, obviously, more news here domestically, with changes in HP and potentially at Kodak. And I'm just wondering if internally, if some of your attention has started to focus back more domestically given the recent changes here. Are you still focused pretty intensely looking at opportunities with Europe?

Jeffrey Housenbold

Yes. I wouldn't characterize that our focus was on Europe. I think we have a balanced focus across the portfolio, and looking at using the balance sheet to try to achieve our strategic objectives where appropriate. So I think we've always looked at how do we extend the court, how do we expand geographically, how do we add additional products and services, how do we take more share of wallet, how do we move in to adjacent markets that make sense given our targeted demographic and their psychographics and demographic makeup. And so I think international expansion is part of that mix. I think there's opportunities that are abound to continue in the U.S. that are within the consolidated core, as well as some of those other strategic areas that I just outlined. So we'll continue to take a balanced approach domestically and international. But any M&A that we do has to fit a number of criteria. First, does it make strategic sense? Second, can you get it at a price that makes sense? And part of getting a price that makes sense is predicated on having a rational person on the sell side. Right? We have to do things that are accretive to our shareholders, that are also strategic. And then the third bucket we think about is post-merger integration. Does it fit culturally? Does it fit from a technical standpoint? Do we think we can add value to the business model, the growth profile, the margin structure. If the answer is yes to all 3 of those, we'll proceed forward. If not, we move on to the next opportunity.

Operator

Our next question comes from Mitch Barlett from Craig-Hallum.

Mitch Barlett - Craig-Hallum Capital Group LLC, Research Division

I'm just wondering, you talked about the meaningful improvement in Tiny Prints' performance since the conclusion of the optimization. Plus, in Q2, Tiny Prints was up like 44%. Are we getting back to kind of the growth rates that existed prior? Or can you put a finer edge on that? And then also, if you could just speak to the core Shutterfly business? And whether -- you've said over the last couple of quarters, the AOV for new customers started to look away from the AOV from existing customers. Is that still the case?

Jeffrey Housenbold

Great. Mitch, I'll take the first one. Mark can talk about the Shutterfly core. Yes, I want to reiterate what Mark said earlier in today's Q&A session that we explicitly had said once we acquire Tiny Prints that we were going to take a company that did 87% -- $87 million in revenue last year with little under 3% EBITDA margin, and moderate the top line growth to increase the profitability of the overall enterprise. And then a number of the strategic levers that we pulled has moderated that growth and gotten the margin significantly higher than they were as a standalone company. The testing that we did in Q3 informed what we thought, given it's the slowest quarter, we thought it was the most sensible quarter to make a number of those tests. So that as we enter into their largest quarter that we had the most informed approach to turning the dials for both top line and bottom line growth. As Mark indicated early into Q4, as we've learned and turned the dials into different directions, we've seen a resurgence of the growth rate on the top line, which gives us confidence that we have our hands on the right dial, and we understand the sensitivities. And so I won't remark about explicitly what that growth rate is, and so we're into a quarter. But we're pleased with the growth rates that are happening on all of the Tiny Prints brands as we head into the seasonally strong fourth quarter.

Mark J. Rubash

And as far as the average order value between new and existing customers, this is with respect to Shutterfly, I'd say it's very consistent delta existing customers coming in, just slightly higher than -- sorry, new customers coming in just slightly higher than existing. The delta that we've seen really for all of this year is pretty consistent in Q3, and those amounts are probably just slightly higher. So new customers slightly more valuable on an average order value this year than last year. But the trend is pretty stable.

Jeffrey Housenbold

Great. Well thank you for joining us this afternoon. This concludes our call and we look forward to speaking with you in the days ahead.

Operator

Thank you. Ladies and gentlemen, thank you for participating in today's conference. This concludes our program for today. You may all disconnect. And have a wonderful day.

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