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Shutterfly (NASDAQ:SFLY)

Q1 2012 Earnings Call

April 30, 2012 5:00 pm ET

Executives

Michael Look - Vice President of Investor Relations

Jeffrey T. Housenbold - Chief Executive Officer, President and Director

Analysts

Mark May - Barclays Capital, Research Division

Heath P. Terry - Goldman Sachs Group Inc., Research Division

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

Kevin Kopelman - Cowen and Company, LLC, Research Division

Operator

Welcome, everyone, to Shutterfly's First Quarter 2012 Financial Results Conference Call. This call is being recorded. I would now like to turn the call over to Michael Look, Vice President of Investor Relations for Shutterfly. Please go ahead.

Michael Look

Thank you, operator. Good afternoon, everyone. Welcome to Shutterfly's First Quarter Fiscal 2012 Conference Call. With us today are Jeff Housenbold, Chief Executive Officer of Shutterfly; And Brian Manca, Chief Accounting Officer. By now, you should have received a copy of our earnings press release, which crossed the wire approximately 1 hour ago. If you need a copy of the press release, you can go to shutterfly.com under the Investor Relations link to find an electronic copy. We have also released a presentation that we will use as we go through this call.

Call participants are advised that the audio of this conference call is being recorded for playback purposes and that a recording of this call, both in streaming online format and to a downloadable podcast, will be made available on our website within a few hours. You can access all of these formats through the Investor Relations section of our website at shutterfly.com.

Before we begin, I'd like to note that our discussion today will include forward-looking statements within the meaning of the Securities Act of 1933 and the Securities Exchange Act of 1934. These forward-looking statements include statements about our business outlook and strategy and statements about historical results that may suggest trends for our business. For more information regarding these and other risks and uncertainties that could cause actual results to differ materially from those expressed or implied in these forward-looking statements, as well as risks relating to our business in general, we refer you to sections entitled "Risk Factors" in the company's most recent annual report on Form 10-K and its other filings with the SEC.

I would also like to note that any forward-looking statements made on this call reflect information and analysis as of today. This presentation contains certain financial performance measures that are different from financial measures calculated in accordance with GAAP and maybe different from calculations or measures made by other companies. A quantitative reconciliation of these non-GAAP financial measures to the most directly comparable GAAP financial measures is available in our first quarter fiscal 2012 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 T. Housenbold

Thanks, Mike. Good afternoon, everyone, and welcome to our First Quarter 2012 Earnings Call. I will begin today's discussion with an update on Shutterfly's progress since our last conference call, followed by the detailed discussion of our Q1 financial results. I will then provide our financial guidance for Q2 and full year 2012 before opening the call up for Q&A.

As you can see from our Q1 earnings press release issued earlier today, 2012 is off to a solid start. We delivered strong Q1 financial results; expanded our core product offerings; launched Treat, our 1:1 greeting card service; and we're successful in negotiating the transfer of Kodak Gallery's customer accounts and data to Shutterfly, further consolidating our market leadership.

Let me take a moment to discuss these achievements in greater detail. Starting with our Q1 financials, we reported revenues of $91.3 million, which represents year-over-year growth of 60% on a reported basis and 18% on a pro forma basis. Q1 solid revenue growth was above the high end of our revenue guidance, reflecting healthy transactional behavior from our existing customer base and solid growth across all 3 of our business categories: Personal Products & Services, Print and Commercial Print services. Our long-standing commitment to innovation, design-forward products and services, customer-friendly policies and industry-leading quality, continues to resonate well with our existing and new customers and enables Shutterfly to differentiate ourselves from the competition.

As a result, we believe we've extended our market leadership during the quarter despite heavy promotional activity from competitors. Our stronger-than-expected revenue growth in Q1 combined with prudent expense management resulted in higher profitability for the quarter. Adjusted EBITDA for the quarter was $600,000 versus our guidance of an adjusted EBITDA loss between $6.5 million and negative $8 million.

Q1 net loss on a GAAP basis was negative $10 million and better than our most recent guidance of a net loss of $11.2 million to $15.4 million. Taking advantage of our market scale and profitability, we continue to make strategic investments in our current products and service offerings, platform infrastructure and people, as well as new product categories, customer segments and supported devices. The benefits of our continued innovation could be seen in the company's early 2012 accomplishments. For example, in February, we launched the yearbook solution that provides parents and the more than 100,000 elementary schools in the United States with high-quality, affordable ways to commemorate the school year. Our yearbook solution includes specially designed page templates to capture school activities along with student, classroom and faculty pictures in bulk discount pricing for 10 or more books.

In March, we introduced premium content for photo books and a number of creation pack enhancements. Our new premium content consists of premium designs and exclusive guided styles for all of life's occasions, as well as individual backgrounds, embellishments and idea pages, further differentiating us in the marketplace and driving higher average order value and profit per book.

Earlier this month, we launched Treat, our new 1:1 greeting card service. Attractively priced at $2.99 per card, Treat offers consumers an easy and innovative way to create personalized greetings that reflect their style, personality and special relationship. Our Treat launch signifies Shutterfly's focused expansion into the 1:1 U.S. greeting card market, estimated to be $6 billion in annual sales, to complement our existing one-to-many card business which addresses an estimated $3 billion U.S. market. The vast majority of the transactions in this combined $9 billion greeting card market are conducted in traditional retail outlets. And we believe Shutterfly is ideally situated to increase market share as users migrate online.

At Treat.com, customers can choose from more than 4,500 customizable designs from some of the industry's leading designers, including hundreds of designs from our new partner, Hallmark. The Treat brand features applications that helps customers manage their getting card needs, such as an integrated reminder service that reminds customers of birthdays, anniversaries and holidays; a Facebook Connect integration that links Facebook and Treat accounts so that customers can import friends' birthdays from Facebook and set up reminders; the ability to add gift cards to their Treat order; direct mail and advanced purchase and delivery scheduling options so cards reach their recipients in time.

Over the next several months, we will continue to expand the breadth and depth of the Treat brand by adding new designs, styles and sentiments to our Treat catalog, introducing new delivery options and launching our Treat iPhone application, which will allow customers to send customized cards anytime from their iPhones. We are excited about the launch of the Treat brand and the additional opportunities that it creates as we continue to help our customers deepen their relationships with the people that matter most in their lives.

In addition to our photo book enhancements and the launch of the Treat brand, we continued to innovate across our products and services during the first quarter. Some examples include: the launch of Shutterfly Videograms that allows customers to tell their stories in a new way by turning their favorite pictures and video clips into a video slideshow with music that can be shared via email and Facebook; new customized iPhone cases that makes great Mother's Day and Father's Day gifts; updates to our sports and baby share sites to include scoreboards, player emails and an easier way for new parents to share their memories; hundreds of new card designs across Shutterfly and Tiny Prints; expanded designs, color filters and pearl paper choices on Wedding Paper Divas; and enhancements to our Facebook address tool and calendar-creation paths.

Moving on to our corporate development activities. We expect to get approval from the bankruptcy court and to close the transaction of Kodak for the transfer of Kodak Gallery's customer accounts and photos to Shutterfly this week. Once this happens, we will immediately begin working with the Kodak team to ensure a smooth transition of the Kodak Gallery customer accounts and offering these newly acquired customers industry-leading products and customer service that will enhance the way they share and preserve their memories.

This transaction is a great example of the consolidation that we believe will play an important role in helping Shutterfly solidify our leadership position in the social expression and personal publishing category.

Moving forward, we will continue to expand our market position through organic growth and disciplined acquisitions that leverage out scale and scope economies, vertical integration, solid balance sheet and profitable business model.

With these initial thoughts on our Q1 progress as a backdrop, I'll now review our first quarter financial results in greater detail. However, before I begin my discussion, I would like to comment on our current disclosure approach and then how it will change going forward.

Over the past year, we have offered detailed Tiny Prints metrics on our quarterly conference calls in order to provide some context as to how our original and combined businesses were performing. Now that we have crossed the 1-year anniversary of the Tiny Prints acquisition, we will not regularly disclose Tiny Prints' specific results or metrics after this call. We will continue to evaluate our disclosure practices to determine if other additional metrics can be publicly shared without disclosing any competitively sensitive information. With that said, let me now review our Q1 financial results.

Total net revenues for the first quarter grew 60% year-over-year to $91.3 million. Excluding Tiny Prints, total net revenues for the quarter were $68.1 million, up 19% from last year. Net revenues from Personalized Products & Services increased 72% to $70.2 million. The increase in our PPS category revenues was largely driven by increased sales of greeting and stationery cards and photo books and includes $23.2 million of revenue from Tiny Prints.

Prints net revenues increased 6% year-over-year to $14.9 million. Commercial Print revenues during the first quarter increased 171% year-over-year to $6.2 million, reinforcing our view that a meaningful Commercial Print opportunity exists for us, as well as highlighting the lumpy nature of this early-stage category of our business. Excluding Commercial Print, net revenues from our core businesses grew 55% year-over-year on a reporting basis and 14% year-over-year on a pro forma basis.

In terms of business category mix, Personalized Products & Services represented 77% of Q1's total net revenues. Prints represented 16%, and Commercial Print revenues increased at 7% of total net revenues.

Taking a closer look at revenue mix by customer category, excluding Commercial Print revenues, Q1 net revenues from existing and new customers at our Shutterfly brand represented 78% and 22% of revenues, respectively. Our strong mix of existing customer revenues highlights the loyalty of our existing customer base and our superior value proposition, as well as the new customer acquisition challenges that this current heavy promotional environment presents.

At our Tiny Prints brands, the mix between existing and new customer revenues was 29% and 71%, respectively, and reflects the lower repeat nature of the Tiny Prints business.

Moving on to the top of our funnel. In Q1, we continued to see solid double-digit growth in key customer engagement metrics such as visits and orders at both our Shutterfly and Tiny Prints brands. First quarter order growth at our Shutterfly brand was 22% year-over-year, and average order value was down 8% year-over-year to $24.60, reflecting lower ASPs as a result of the heavier discounting.

At our Tiny Prints brand, excluding 1:1 greeting cards, order growth was 17% year-over-year, and average order value remained essentially flat at $97.

Moving to cost and net revenues and gross margins. We reported a gross margin of 45.2% in Q1, which is above the high end of our guidance range and down from the 48.4% margin we reported last year. A year-over-year decrease reflects the combined effect of deeper-than-normal discounting levels in our core products and increased percentage of Commercial Print revenues, which have lower gross margins, and the inclusion of Tiny Prints' customer service and outsourced manufacturing costs, partially offset by a favorable shift in product mix from prints to photo books and cost efficiencies in manufacturing.

Turning now to operating expenses, excluding stock-based compensation. Overall, operating expenses totaled $51 million, reflecting an increased cost structure of the combined business and purchase accounting amortization, offset by a delay in the timing of various marketing programs and acquisition synergies.

Looking more specifically at our operating expense components. Technology and development costs totaled $19 million for the quarter or 20% of net revenues. Excluding stock-based compensation and depreciation, our technology and development spending increased approximately $3.7 million or 37% from the prior year. The increase in tech and dev spending reflects the addition of the Tiny Prints technology team, together with the incremental investments in engineering headcount to drive future innovations.

Sales and marketing expenses totaled $27 million in the quarter, representing 30% of net revenues compared to 25% in Q1 of 2011. Excluding stock-based compensation and amortization, sales and marketing expense increased approximately $9 million from the prior year and represented 23% of net revenues and essentially in-line with Q1 of last year. The year-over-year increase largely reflects the addition of the Tiny Prints marketing team.

General and administrative expenses for the quarter totaled $15 million or 16% of net revenues. Excluding stock-based compensation and credit card processing fees, G&A expenses represented 10% of quarterly net revenues, down from 13% in Q1 of last year, which excludes the Tiny Prints transaction costs that were recorded in the first quarter of 2011. The year-over-year decrease primarily reflects integration synergies that have resulted from a combination of the 2 businesses.

As I indicated earlier on this call, adjusted EBITDA for the quarter was $600,000, significantly better than our most recent guidance, which projected an EBITDA loss of $6.5 million to $8 million. This favorable EBITDA performance was driven largely by solid revenue growth combined with continued operational efficiencies.

The effective tax rate for the quarter was 48%, which reflects the impact of disqualifying dispositions of incentive stock options during the quarter.

On a GAAP basis, our net loss for the quarter totaled $10 million for a loss of $0.29 per share, an improvement from our previous guidance. The weighted average shares used to calculate the net loss per share totaled $35.2 million.

And finally, capital expenditures during the quarter totaled $9.6 million, including $2.5 million for the technology, equipment and software; $4 million for manufacturing equipment and building improvement; and $3.1 million in capitalized research and development cost. Cash and liquid investments at quarter end totaled $144 million.

To complete my discussion today, I would now like to summarize our outlook for the second quarter and full year 2012. As I indicated earlier in this call, we expect to get approval from the bankruptcy court and to officially close our transaction with Kodak this week. Therefore, our guidance today includes the estimated impact of the pending Kodak transition. As I stated early in this call, 2012 is off to a solid start. Our commitment to innovation, design-forward products and services, customer-friendly policies and industry-leading quality continues to enable Shutterfly to differentiate ourselves from the competition and extend our market leadership. The competitive landscape, however, remains uncertain as we continue to see elevated discounting behavior from our competitors throughout Q1 and into Q2.

In addition, we are mindful of the current state of the economy, a highly volatile financial market and the impact the external factors may have on consumer discretionary spending. All of these factors, combined with our limited experience in managing our newly acquired Kodak Gallery customer base, are incorporated into our Q2 and full year 2012 guidance.

In terms of Q2 net revenues, we expect stable non-holiday growth rates with increased activity during the Easter, Mother's Day, Father's Day and graduation period at our Shutterfly, Tiny Prints and Treat brands, with minimal revenue coming from the Kodak Gallery customers as we begin the process to transfer their accounts and data to Shutterfly. During the second half of 2012, we expect net revenues to follow their normal seasonal trends.

Turning now to operating expenses. Upon closure of the Kodak transaction, we will move quickly to transfer Kodak Gallery's customer accounts and data to Shutterfly. This migration is expected to result in incremental, non-recurring costs related to maintaining Kodak's current network infrastructure and website during the transition phase, plus increased storage, power, bandwidth and technical support costs. In addition, we expect to also incur significant one-time incremental customer service and marketing costs associated with implementing marketing campaigns that promote the migration of Kodak Gallery customers to Shutterfly.

With these comments as context, I will now summarize our guidance for -- starting with Q2. Currently, we expect Q2 net revenues to range from $90 million to $92 million, which reflects year-over-year growth of up to 21%, with very minimal revenue from Kodak. We expect our GAAP gross margin to range from 44% to 45% of net revenues, reflecting scale and scope efficiencies in our production facilities combined with lower Commercial Print revenues in Q2.

Q2 GAAP operating loss is expected to range from $24 million to $27 million. Q2 adjusted EBITDA is expected to range from a loss of $2 million to $4 million, and assumes approximately $2 million to $2.5 million in incremental non-recurring expenses related to our Kodak transaction.

Our GAAP effective tax rate will be approximately 50%. We expect our Q2 GAAP net loss per share to range from a loss of $0.33 to a loss of $0.37, based on approximately 36.4 million weighted average common shares.

Turning now to the full year 2012. We estimate that net revenues will total between $576 million and $586 million, which reflects year-over-year growth of up to 24% on a reported basis and approximately $21 million in revenue from Kodak. We are maintaining our full year GAAP gross margin guidance range of 52% to 54% of net revenues. We expect that our GAAP operating income will range from approximately $5 million to $12.2 million.

For the full year 2012, we expect adjusted EBITDA margin to range from 16.5% to 17.5% of net revenues, based upon the assumption that Kodak will be approximately breakeven on an adjusted EBITDA basis in calendar year 2012.

The full year GAAP effective tax rate is expected to be approximately 50%. We expect full year GAAP net income per share to range from $0.07 to $0.16 per share, based on 38.3 million weighted average diluted shares.

And finally, we now expect the 2012 capital expenditures will range from 8% to 9% of net revenue, reflecting Shutterfly's increased data storage requirements associated with the migration of Kodak Gallery customers' accounts and data.

In summary, Shutterfly began 2012 with solid momentum across all of its business categories. Our market-leading scale and profitability enabled us to continue to make strategic investments in our core products and service offerings, platform infrastructure and people. These investments enabled us to enhance and expand our current products and services, enter new product categories and address new customer segments.

In addition, we were able to further consolidate our market leadership through the disciplined acquisition of a key competitor's customers accounts and data. We believe that our Q2 and revised full year 2012 financial guidance gives appropriate weight to our most recent business performance, current market conditions and our best estimate as to the impact of our proposed Kodak transaction.

So with that, we will now open the call for your questions.

Question-and-Answer Session

Operator

[Operator Instructions] Our first question comes from Mark May from Barclays.

Mark May - Barclays Capital, Research Division

I had 2. I wonder, Jeff, if you could characterize your expectations for the pricing promotional environment for the rest of the year? Would you -- are you expecting a stable environment? More favorable? Or less favorable? And then secondly, if you were to exclude the transition costs related to the Kodak Gallery transaction and think about how the business operates more on a normalized basis, maybe 12 months out or so, what would the margin, the incremental margins look like for that incremental revenue? Would they be roughly in line, below, or above the company's current corporate average?

[Technical Difficulty]

Michael Look

All right. Sorry about that. Go ahead, Mark.

Mark May - Barclays Capital, Research Division

Okay. Should I ask my -- re-ask my questions, I guess. Okay. First one, I wonder if Jeff could characterize his views on the pricing promotional environment for the rest of the year? Is your expectation that it's relatively stable, more favorable or less favorable than what you've seen over the last 3 to 6 months? And then secondly, if you were to exclude the transition cost from the Kodak Gallery deal and look at this business may be more at a normalized scale, 12 months out or so. How should we think about the margins of that incremental revenue? Is it in line, better or worse than the company's current corporate averages?

Jeffrey T. Housenbold

Great. And sorry, everyone, for the technical difficulties. Mark, on the pricing and promotional environment, similar to when we gave out guidance on the last call, we anticipate and incorporate into our full year 2012 guidance is the steady-state promotional environment that we're seeing, which is, I would characterize as elevated from the prior few years. So we saw that beginning in the end of Q3 of 2011 continuing to Q4. We've seen that through Q1 and into early Q2. So our beat in the first quarter on revenue and on EBITDA was still in an environment where we see competitors continuing to do irrational pricing. But our scale and scope economies and profitable business model allow us to continue to grow market share. On the Kodak, I think the best way to think about Kodak -- and I'll give you guys a pretty detailed perspective. Kodak had approximately $70 million in revenue last year. They saw declines of about 30% in revenue in the first quarter since they announced bankruptcy. And then we assumed that not what 100% of the customers would come over to Shutterfly, and then about 60% of their revenue occurs in the third and fourth quarters when we're finished with the transition period and we'll be able to start generating revenue on the Shutterfly platform in early July. That gives you kind of a sense of how to model and how we derived $21 million for this year. As I indicate in my prepared notes, we believe the Kodak business will be roughly EBITDA breakeven for 2012, but this will have meaningfully higher EBITDA contribution than the core business because we don't have the same costs associated with this incremental revenue once we get past the transition costs, because we're just acquiring the customers, photos and their data and not taking a platform or the marketing expense associated.

Operator

Our next question comes from Heath Terry from Goldman Sachs.

Heath P. Terry - Goldman Sachs Group Inc., Research Division

I was wondering if you could give us almost kind of a realtime update of your sense of what the competitive environment looks like? We, just in our own checklist, started to see some signs that maybe things are starting to get a little bit more reasonable and wondering if you're seeing the same thing? And to what extent the market or that pricing environment starting to change, how quickly you expect that to have an impact on your business if indeed you are starting to see that?

Jeffrey T. Housenbold

Yes. So Heath, we've seen -- throughout Q1, there were still pretty heavy discounting led this quarter again by HP Snapfish, where they were doing things as deep as buy 1 photobook, get 2 free and get 150 free prints and a free photo book for Mother's Day. As early as last Friday, they issued that promotion. So that kind of competitive pricing which, again, we said we don't think is sustainable over the long term, we're assuming will continue throughout 2012. If we do see an abatement and things are more reasonable throughout the year, then we believe there's upside to the guidance that we issued on today's call. Most of that will likely come in the fourth quarter where the disproportionate amount of our revenue and all of our profits are derived.

Heath P. Terry - Goldman Sachs Group Inc., Research Division

And so I understand you kind of saw that through Q1, to the extent that we're kind of 4 weeks into Q2 now. Any changes at all from the run rate that you were seeing in Q1 from a competitive standpoint?

Jeffrey T. Housenbold

Nothing that I think is remarkable or any -- we don't have enough data points to see a consistent trend. I do think as people start to do the analytical work on the promotional programs they're running and some of the lifetime values on the customers they're acquiring through Flash and coupon sites, that I think the data is going to speak for themselves and that things will get more reasonable. But we haven't seen a remarkable change from Q1 to date.

Operator

Our next question comes from Shawn Milne from Janney Capital.

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

Jeff, I wanted just to follow-up a little bit on the Kodak mass. Now if you -- so if you're seeing them fall off at 30% and you're thinking sort of the same kind of seasonality, 60%, we still getting a bigger number than $21 million. So I guess, is that your -- you're taking it down based on the level of churn that -- from their customer base in terms of migration? And then, yes, I know some of the transfer costs are online in the court documents, but when do you -- I'm trying to understand your comments between what would be non-recurring, the data warehouse costs versus -- I'm assuming there'll be some level of ongoing marketing to those customers. Just trying to break out the difference between what would be a normal operating cost versus a non-recurring cost, if you can help us there.

Jeffrey T. Housenbold

Sure, Shawn. So again, if you take roughly $70 million last year, you back out a couple of million dollars of international revenue that we won't be getting because we're only picking up the North American, U.S. and Canadian customers, you then take a 30% haircut to that because of the decline since they announced bankruptcy. You then take a haircut because not 100% of those customers will opt out -- continue to opt in, sorry, into the deal. And then you take a haircut for the fact that we're only going to get revenues kind of July -- the first week of July onwards. That gets you roughly to your $21 million. There could be upside to that if we are successful in reactivating...

[Audio Gap]

Jeffrey T. Housenbold

...a small portion of the 70-plus million registered users data that we're getting, the vast majority of those obviously are not active transactional customers, but they're people who have expressed interest in either sharing or purchasing from Kodak in the past. And given our world-class CRM and segmentation capabilities, we think there might be some upside as we try to reactivate those customers. As we think about the expense side, in the court papers, as you indicated, we would -- we are paying $700,000 up to 9 months to keep the Kodak website up and employ the people required to do so at Kodak. So that's approximately $6.3 million in OpEx there. We have to buy storage to migrate these petabytes of data over, and storage costs are slightly elevated right now because of the Thailand floods. And so we're seeing that impact us as we're going out in the market and buying large amounts of that, given that Facebook and Google and Amazon continue to buy a lot of disk drives as well into the market. We will then offer some promotions, if you will, to those customers to migrate, and we'll have some increased CRM costs. But when I think about the one-time costs versus ongoing, the CRM and the marketing costs are relatively de minimis. We'll add some additional people in I ops, CRM, customer service to support that increased customer base. But as you look into 2013, on an incremental basis, the revenue on a full year coming from the Kodak customers should be meaningfully higher in EBITDA margin than our existing 17% to 18% guidance prior to the most updated with Kodak in it at 16.5% to 17.5%.

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

That's helpful. And just a quick follow-up, we saw the core Shutterfly AOV, I believe, was down 3% in Q4, if I've got that right, and was down 8% this quarter. Again, is that -- you talked about the heavy pricing environment, but we also noticed that you went back to the Flash sales channels, that part of the AOV impact. And is this the trough of how deep you think the AOV decline will be? Or is this going to be -- kind of how you would view it for the year?

Jeffrey T. Housenbold

I think Q4 is going to be the telltale. And so I can't foresee what the competitors are going to do in Q4. But we have essentially given that we have the highest price point and the lowest cost because we're vertically integrated. We've made the strategic decision to be aggressive on discounting but not to the point of the irrationality of some of the competitors and yet still do that in a meaningful profitable level. And you saw that in a positive EBITDA contribution in Q1. So we traded off about 8% in AOV in the first quarter for 22% increase in orders and an 18% increase in transacting customers, beating our high-end of our guidance on the top line and on the adjusted EBITDA line. So because of our scale and scope economies, we think we're in the best position to manage through this time of elevated discounting. And if there is an abatement of that, we think there is upside to that. So I think if we look at Q3 and Q1 kind of mid- to high-single digit AOV decline, I think that's a fine place to model for now, and we'll see more. Obviously, we'll update that as we get actual data throughout the year. But keep in mind, we're trying to do things to offset that AOV decline. I mentioned in my script, we rolled out premium content, which, for $4.99 a book, customers can choose exclusive designs or for ala carte, $0.25 to $0.99 for different embellishments and design elements. So we're going to continue to try to upsell our customers to premium products and services. But the overall discounting environment is going to likely dampen AOV throughout the next few quarters.

Operator

Our next question comes from Kevin Kopelman from Cowen And Company.

Kevin Kopelman - Cowen and Company, LLC, Research Division

Could you give us a sense of general consumer demand for your core products, just leaving aside any pricing issues at the moment? And then also, could you just give us -- could you just touch on commercial printing for a bit? What were the key drivers in Q1, and what are you expecting in that business for Q2 and the rest of the year?

Jeffrey T. Housenbold

Yes. So we continue to believe we're in the earliest days of migrating this $30 billion, $35 billion U.S. market that is largely off-line and in retail, centered around static and generic content to an online dynamic world where customers can personalize their sentiments and make truly remarkable one-of-a-kind products and gifts that enable deeper, more personal relationships between them and those that matter most. And so if you look -- at our best estimate is we're still in the single digits penetration online into these very, very large multibillion dollar markets. And so the consumer demand is still quite high, and you're seeing more and more of that personalization appear in different products and services like our newly launched iPhone cases. So we think we're still at the beginning of this transformation. As it relates to Commercial Print, very pleased with the team's progress and success through Q4 and Q1. As you know, they continued to win new clients and also extend our relationships with existing clients as clients continue to be delighted by our quality, our accuracy, our analytics and our overall account management. We think we're best positioned to utilize our best-in-class digital print on demand capabilities across the Fortune 1000. And so I'm very excited about the future of that business. And as we said, as we achieve scale, $20 million, $30 million in revenue, we think that will have a very nice flow-through to free cash. We don't give specific guidance on commercial because of its early nature and also because of the lumpiness. It looks more like an enterprise sale, slow, than a consistent consumer demands where we have quarters and quarters of history. But we are excited about the recent progress, and we remain strong believers that this will be an important contributor to the future growth of Shutterfly.

Operator

This ends our Q&A session, I'll pass it back to management for closing remarks.

Jeffrey T. Housenbold

Thank you, everyone, for joining us on our Q1 2012 call. As I indicated, we're off to a very good start. I think our leadership position continues to strengthen, given the amount of innovation that we're driving across all 4 of our brands: the launch of Treat, some of the enhancements to our Photo Book and cards & stationery line and our overall scale and scope economies given our profitable business model and our industry-leading vertical integration. So we look forward to catching up with you guys on the road and also speaking at the end of the quarter. Thanks, again.

Operator

Ladies and gentlemen, thanks for participating in today's program. You may all disconnect. Have a good one.

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