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Shutterfly, Inc. (NASDAQ:SFLY)

Q4 2007 Earnings Call

February 6, 2008 5:00 pm ET

Executives

Marilyn Lattin – Director Investor Relations

Jeffrey T. Housenbold – President, Chief Executive Officer & Director

Mark J. Rubash – Chief Financial Officer

Analysts

Imran Khan – JP Morgan Securities Inc.

Yousseff Squali – Jeffries & Company

Kristine Koerber – JMP Securities LLC

Aaron Kessler – Piper Jaffray & Co.

Shawn Milne – Oppenheimer & Co., Inc.

Jeffery Shelton – Natixis Bleichroeder, Inc.

Operator

Good day and welcome to the Shutterfly fourth quarter and fiscal 2007 earnings conference call. As a reminder today’s call is being recorded. I would now like to turn the call over to Ms. Marilyn Lattin, Director of Investor Relations. Please go ahead ma’am.

Marilyn Lattin

Good afternoon everyone and welcome to Shutterfly’s fourth quarter and full year 2007 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 www.Shutterfly.com and an archived copy will be kept on our site. We’ve 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 www.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 the business. For more information regarding these risks and uncertainties that could cause actual results to differ materially from those expressed or implied in these forward-looking statements as well as risks relating to our business in general we refer you to the section entitled risk factors in the company’s latest 10Q and other 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 includes an adjusted EBTIDA measure that is a non-GAAP measure that is different from financial measures calculated in accordance with GAAP and maybe different from adjusted EBTIDA or EBITDA calculations made by other companies. A quantitative reconciliation of adjusted EBITDA to the most directly comparable GAAP financial measure has been included in this presentation and is available in our Q4 and full year 2007 earnings press release which is posted on the investor relations section of our website at www.Shutterfly.com.

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

Jeff

Thank you all for joining us on our Shutterfly’s fourth quarter and full year 2007 earnings call. As on our previous calls our agenda will start with the review of key accomplishments for the year including some recent announcements. Then, I’ll turn the call over to Mark to review our financial performance in detail and provide guidance for Q108 and full year 08. I’ll close with some comments about our goals and objectives for 2008 and then we’ll open up the call to answer your questions. Let’s get started.

2007 marks our 8th full year of operations, my third year as CEO of Shutterfly and Shutterfly’s first full year as a public company and by any measure it was an exciting year for the company. We grew top line revenues by 51% and we increased bottom line net income by 74%. We expanded our offerings and personal products and services and we drove strong growth in our prints business. Total customers and orders increased substantially with continued strong repeat business from repeat customers. All of this activity lead to record revenue, profit, customers, orders and average order value. We are very pleased with our fourth quarter and full year results. Our consistent execution and our relentless customer focused combined with our continued investments in our premium consumer brand have translated into outstanding financial results.

Now, I’ll summarize our operation accomplishments as they relate to the five key objectives for 2007 that I first described in our 2006 earnings call. Our first objective was to expand our premium lifestyle brand through results driven, integrated advertising, PR and merchandising. In 2007 we conducted many successful marketing campaigns targeting key verticals such as wedding, baby, pets, travel and scrapbooking as well as key holidays including Valentine’s Day, mothers and fathers day, summer vacation, Halloween and of course the Q4 holidays. These efforts drove increase trial and purchases throughout the entire year.

We also created new ways to enhance the sense of community on Shutterfly by incorporating our enthusiastic customers into our marketing mix. We call it tell your story and it’s now our tagline. For the 2007 holidays we included real Shutterfly customers, their stories, their pictures and their holiday traditions in our holiday and advertising, our website visuals and in our catalog. Our goal was to inspire customers, and demonstrate how real people are using Shutterfly to create unique and memorable photo keepsakes and stay connected to friends and family. Response from tell you story strategy has been excellent and this new advertising campaign drove demonstrable results in Q4. For example, in magazines such as Cookie and Real Simple consumer awareness of Shutterfly ads was in the top 10 of all advertisers. Equally important, after seeing Shutterfly’s print ads consumers were substantially more likely to visit our website.

In Q4 successful direct mail initiative featuring our seasonal catalog which was targeted at both new and perspective customers resulted in higher conversion and average order value for both segments. In addition to advertising Shutterfly continued to use consumer and business PR to increase awareness and trial. During 2007 Shutterfly garnered 3.8 billion PR impressions which included 1,400 print mentions and over 140 broadcast spots. In Q4 alone PR impressions were up 700% year-over-year.

Our second objective was to extend Shutterfly’s points of differentiation and competitive advantage by creating new high quality products and services. In 2007 we expanded both our print and our personal products and service offerings. In personalized products and services we expanded our lineup of holiday cards, adding many new form factors, styles and borders, introducing a line of high end designer greeting cards and expanding options on our popular collage cards. New calendar innovations included collage photos, personal dates, additional page boarders and new sports, travel and wedding themed backgrounds. Our award winning photo book line expanded to include different holiday themes and life occasions such as wedding, baby, sports, pets and travel as well as new licensed content from Sesame Street, Dora the Explorer and Diego. Customer adoption on new products was strong across the entire assortment reinforcing our belief that listening closely to our customers and providing them with fresh options to tell their story is a winning formula.

On the Q3 conference call I described how we delivered the largest website feature release in the company’s history which included adding search capabilities to the website, a fully screen slideshow for viewing photos and projects, live chat for customer service and a homepage makeover featuring interactive flash based merchandising tools to improve the shopping experience and increase conversion. We also redesigned our storage platform resulting in reduced total cost of ownership. This technology investment allows Shutterfly to uniquely provide free unlimited storage with no compression, no down sampling and no forced deleting of our customer’s images.

Our enhancement of the Shutterfly community continues, most recently with the acquisition of Nexo and online sharing and group services provider with a next generation platform for easily creating customized content rich personal and group websites. The decision to acquire Nexo was based on our experiences with Shutterfly Collection, the personalized URL that allowed customers to post and blog about their photos within a secure password protected environment and with the summer memories campaign where customers shared their vacation photo books online. Both of these initiatives reinforced our belief that compelling community features can accelerate viral, cost effective customer growth and increase ecommerce transactions. We believe that the Nexo acquisition is an exciting evolution in Shutterfly’s community offerings and will help us maintain our leadership in permission based online sharing and collaboration.

Our third objective was to executive on a focused number of high impact initiatives to further penetrate large markets. These initiatives included new business relationships to drive customer acquisition and retention, our pioneering accomplishments with the scrapbooking market and our introduction of premium designer cards which allows us to penetrate the adjacent market for social stationary. I’ll start with a quick recap about business relationship with Target which continues to progress very well. In Q3 we implemented a Shutterfly branded in store marketing presence in Target stores. In addition, Target began running Shutterfly ads in its circulars reaching more than 50 million households weekly. In Q4 our co-branded presence at www.Target.com delivered a healthy stream of new customers and provided further choice for people who wanted to pick up prints at retail. In Q4 we enhanced our in store presence with the merchandising display booth in the electronics department. We learned a lot about merchandising placement, product displays, in store locations and what items driven consumer interest in trial from our Q4 holiday test. Based upon these learnings we are further refining our 08 roll out strategy with Target to optimize the benefits to both partners.

As I said before, we believe that social expression and personal publishing is comprised of many very large and formally separate markets that are now more accessible and expanding due to innovations in web based technologies and on demand digital publishing. During the last 12 months we have delivered two exciting proof points of this market transformation with our pioneering efforts in the scrapbooking market and our entrée into the premium online social stationary market. In 2007 we formed a digital scrapbooking advisory team comprised of industry thought leaders. Our close collaboration with these scrapers lead to the introduction of 8x8 and 12x12 scrapbooking pages, downloadable scrapbook templates and a sponsorship of Shutterfly’s very successful scrapbooking holiday blog. Last week we demonstrated continued commitment to the scrapbooking community when we announced an important relationship with CK Media Scrapbooking. CK is the publisher of this industry’s most authoritative widely read craft and scrapbooking magazines and it also runs widely attended education classes at scrapbook conferences throughout the entire country. We believe this relationship will help introduce Shutterfly to millions of paper and digital scrapbookers and aligns us with a premier brand and designers within the industry.

Also, we announced a premium baby stationary card collection that enables parents to celebrate their newborns arrival with stylish announcements, invitations and thank you notes. This exclusive high end designer stationary collection features fresh, unique and sophisticated designs. It’s another tangible example of how Shutterfly is expanding our region to social stationary within the transformative markets for social express and personal publishing.

Our fourth objective in 2007 was to make strategic investments in manufacturing, process and technology to ensure rapid innovation, high quality, high customer service and favorable margins. Both our Hayward, California and our Charlotte, North Carolina facilities were highly productive during the fourth quarter. Although Q4 was Charlotte’s inaugural holiday season we are already seeing early indication of efficiencies in that facility in labor costs, power and in reduced shipping costs to east coast customers. In addition, a combination of streamlined processes and better use of equipment in both facilities has enabled us to accelerate production throughout throughput of both cards and photo books.

Our fifth and final objective in 2007 was to continue making Shutterfly a great place to work and we succeeded in attracting top talent at all levels in the organization. I’m especially pleased with key additions to our executive management team. Early in 2007 Dwayne Black joined as SVP of manufacturing operations most recently from RR Donnelley. Kathryn Olson joined Shutterfly in Q2 as chief marketing officer bringing more than 20 years experience building brands and market share to leading consumer companies such as LeapFrog, Wrigley, Nordstrom and Quaker Oats. In Q4 my former eBay colleague Mark Rubash become our Chief Financial Officer and during his tenure at eBay Mark led the finance organization when the company grew revenue from $450 million to over $5 billion. Early in his career Mark was an audit partner at Price Waterhouse Coopers where he served as a global lead for the firm’s Internet industry practice. Lastly, this past month we hired Peter [Naven] as our new head of human resources. Peter will focus on scaling out people assets and making Shutterfly a great place to work. Peter has a breadth of HR experiences across both established companies and hyper growth start ups. Most recently he was vice president of human resources. Dwayne, Kathryn, Mark and Peter along with Doug Galen now SVP of corporate development and Stanford Au, SVP of technology comprise my executive leadership team. This experienced team with guide our continued growth and our strong execution.

So, that summarizes the sum of our accomplishments in 2007. It was a fantastic year and we are very pleased with our accomplishments. I want to personally thank all of our employees for the tremendous contributions not just in the seasonably high intensity fourth quarter but throughout the entire year. With that I’ll now turn the call over to Mark to walk you through the numbers.

Mark

Before discussing our latest financial results I’d like to take a minute to express my sincere thanks to Steve [Recht] for all his support and counsel during my first two months and for his significant contribution to Shutterfly. His thoughtful and experienced leadership has served the company well and he will definitely be missed by all. I’d also like to reiterate that I am personally very excited about this new role at Shutterfly as well as the quality of our team and the tremendous market opportunities that lie ahead. Throughout my career whether in public accounting as a senior member of corporate finance organizations or as a CFO, I’ve had the opportunity and often the requirement to evaluate the financial health and organizational strength in companies in a variety of industries. With this combination of accounting and operational finance experience taking a critical look at new environments is a very natural and comfortable activity for me. During the past 60 days I have been very active here at Shutterfly meeting the team, learning the business and working extensively on our 2008 operating plan and while I’m still in the early days, I thought it’d be useful to share my initial insights and observations and how they’ll frame my focus for 2008 and beyond.

First of all, I believe Jeff and the entire team should be congratulated for the progress they’ve made. Shutterfly has executed well in the early stages of multiple billion dollar markets and has already demonstrated the ability to generate strong revenue growth while consistently improving annual profitability. I believe this type of top line and bottom line discipline is essential in growing Shutterfly’s long term market value and that we must continue to carefully balance investments for the long term with an even greater focus on increasing overall profitability and free cash flows.

Second, like many ecommerce companies Shutterfly operates in markets with inherent seasonality which requires that we plan our operations around periods of peak volume that don’t always coincide with our calendar quarters. While seasonality is a fact of life at Shutterfly to optimize our manufacturing capacity we must continue to extend our products and services into new use occasions and non-peak periods. It also means that we must be extremely diligent in managing all elements of our manufacturing cost structure and constantly seek out opportunities to achieve greater leverage in our labor, materials and shipping costs as well as manufacturing overhead.

Finally, successful business models will always attract competition both direct and indirect and that means there will always be challenges to our value proposition. In an intensely competitive environment maintaining and extending our leadership position requires that we strive to improve our operating efficiency and productivity at every level. In short, we have to ensure that every dollar we spend has a potential business return and that every dollar goes to its highest and best use. I had the opportunity to practice this form of close business unit finance collaboration with Jeff during our time at eBay and look forward to building on Shutterfly’s existing foundation of performance based metrics driven execution.

We these few thoughts in mind let’s now turn to a review of our Q4 and 2007 financial results starting with Q4. Net revenues totaled $97.5 million representing 49% year-over-year growth, our 28th consecutive quarter. Personalized products and services contributed $61.9 million or 64% of total net revenues. In addition to 55% year-over-year growth this strong revenue performance is clear validation that our personalized products and services strategy is working. Net revenues from print totaled $35.6 million up 39% year-over-year and nearly double the 20% annual market growth sited by IDC. Prints represents 36% of total Q407 net revenues. Our goal is to deliver the highest print quality and overall print value and this strong year-over-year print revenue growth confirms the effectiveness of our premium brands and pricing strategies. The split of net revenues between new and existing customers remained in line with previous quarters and with net revenues from existing customers contributing 72% of the total and net revenues from new customers delivering the remaining 28%. In a time of increasing consumer choice and varying value propositions we’re very pleased to see this continued strong revenue growth from our loyal and quality oriented customer base.

Moving on to gross profit, our Q4 margin was 60% consistent with 60.2% reported last year and at the high end of our guidance. Q4 marked the launch of our new Charlotte manufacturing facility and with it came the inherent cost associated with first year start up, training and burn in activities. Despite these incremental and largely non-recurring costs, the lower operating cost environment in the Charlotte area combined with a more efficient plant layout and strong execution by our team allowed us to maintain a healthy and consistent gross margin. Overall, we’re extremely pleased with our first year performance in Charlotte and with the cross collaboration between the two facilities. During 2008 and beyond we will continue to seek further leverage in the areas of labor, facilities and shipping cost as well in manufacturing production efficiency.

Operating expenses for the quarter excluding stock based compensation totaled $30.9 million or 32% of net revenues as compared to the $20 million and 30% reported in Q406. The slight year-over-year percentage increase was attributed primarily to investments in our marketing programs that continue to focus on revenue growth and new customer acquisition. Adjusted EBITDA during Q4 totaled $33.1 million or 33.9% of net revenues. This performance was near the high end of our Q4 financial guidance and represents 45% year-over-year growth. The Q4 effective tax rate was 39%, higher than expected with the increase primarily resulting from higher levels of stock based compensation combined with a lower volume of disqualifying dispositions of incentive stock options.

Moving on to the rest of the income statement Q4 GAAP net income totaled $16.9 million or $0.63 per diluted share. This bottom line performance compares very favorably with the $12.2 million net income and $0.50 per diluted share reported in Q406.

Turning now to our full year 2007 results; net revenues total $186.7 million a 51% year-over-year increase and a healthy acceleration over 2006 net revenues of $123.4 million. Net revenues from personalized products and services were $105.3 million an increase of 69% over 2006. Personalized products and services represented 56% of total net revenues during the year versus 51% of net revenues in 2006. For the full year net revenues from prints increased to $81.4 million a 34% year-over-year increase and again well ahead of the 20% annual industry growth rate reported by IDC.

The 2007 gross profit margin was 55% and in line with our financial guidance. As mentioned earlier costs of net revenues include certain first year start up costs for our new Charlotte facility which were partially offset by labor and shipping savings. Excluding stock based compensation operating expenses for 2007 totaled $87.7 million or approximately 47% of net revenues consistent with 2006. 2007 adjusted EBITDA totaled $32.9 million or 17.6% of net revenues compared to the $21.6 million and 17.5% margin reported last year. Our year-over-year growth in EBITDA was 52% comparing very favorably to our 51% growth in net revenues. Our full year effective tax rate was 38.6% and as mentioned previously higher than our expectations primarily due to increased levels of stock based compensation and a lower volume of disqualifying dispositions of incentive stock options. GAAP net income for 2007 totaled $10.1 million a 74% improvement over the net income of $5.8 million reported in 2006.

While there’s more work to be done we’re very pleased with the fact that we increased bottom line profitability while making strategic investments to expand our market share, diversify our product and service offerings, increase our manufacturing capacity and adding to our management strength. Net income per diluted share for 2007 totaled $0.38 as compared to the $0.56 per diluted share reported in 2006. Capital expenditures during 2007 totaled $35 million or 18.7% of net revenues. This amount is in line with our previous financial guidance and includes the incremental costs associated with our Charlotte plant partially offset by efficiencies in the costs of site operations. The company ended the year with $125.6 million in cash, cash equivalents and short term investments and consistent with prior years the close of Q4 continued to represent the highpoint for our cash and investment balances.

To wrap up my discussion of Q4 and full year 2007 I’d like to summarize some of our key metrics starting with Q4. Customers increased 45% year-over-year to 1.4 million, orders increased 44% year-over-year to 2.7 million and average order value was $36.80 reflecting a greater proportion of net revenues from personalized products and services during this gift giving quarter. For the full year 2007 customers increased 37% year-over-year to 2.4 million, orders increased 38% year-over-year to 7.1 million and average order value for the year was $26.44 up 9% from the $24.16 level reported in 2006.

Now I’d like to provide some additional context on 2008 together with our financial guidance for Q1 and the full year. First, while we are pleased with 2007 results we’re thoughtful about the potential impact the current economic environment might have on our business. We continue to believe that memory preservation and sharing are fundamental and highly valued consumer activities however, we also understand that no company is immune to economic downturn. As a result we will continue to man a strong focus on our business fundamentals and on trends in the buying behavior in our customers.

Second, I started my remarks with a comment on the seasonality of our business. As you may already know we continue to introduce new products and services with a goal of expanding our business around new use occasions and in non-peak periods. While we are making great strides in this area based on our 2008 product road map and the continued strong growth in new customer acquisition we believe that Q4 will account for an increasing proportion of our 2008 net revenues and adjusted EBITDA profits and that our Q1 through Q3 seasonality patterns will be very similar to our actual results in 2006.

Third, we operate in the early stages of several very large markets. We believe that maximizing long term shareholder value in this environment will continue to require investment to build our customer base, increase our market share and generate sustainable top line revenue growth. Finally, we firmly believe that delivering strong top line growth and increasing bottom line profitability must go hand-in-hand. In fact, we believe that the focus on growth and profits is a fundamental characteristic of great companies. During 2008 we will continue efforts to optimize our manufacturing capacity, cost structure and processing efficiency both within and outside California as well as ensure we have the operational systems, processes and talent necessary to achieve our profitability objectives.

With these remarks as context I would now like to summarize our initial financial guidance for the first quarter and full year 2008 starting with Q1. With consideration for both the potential impact of the changing economic environment and the likely increase in 2008 fourth quarter seasonality we expect net revenues to range from $34 to $36 million which translates to year-over-year growth of approximately 27 to 35%. We expect our gross profit margins to range from 50 to 51% of net revenues roughly consistent with the 51% rate reported in Q1 of 07. We expect our adjusted EBITDA margin will range between a loss of $1.8 million to a loss of $2.3 million reflecting increased first quarter seasonality, initial integration of the Nexo platform and planned investments in ERP and other key information systems. We expect our Q108 effective tax rate will approximate 42% reflecting the lower level of quarterly profitability combined with a conservative assumption on the level of disqualifying dispositions of incentive stock options. It is important to note however that due to the availability of net operating loss carry forwards our actual cash tax rate for 2008 is expected to be substantially less than the effective rate and for purposes of calculating the net loss per share the weighted average common shares for the quarter are expected to approximately 24.9 million.

Turning now to our full year 2008 guidance we currently estimate that 2008 net revenues will total between $245 and $255 million reflecting year-over-year increase of 31 to 37% and an increase to the low end of our prior guidance. We expect the full year 2008 gross margin to range from 53 to 55% of net revenues. This guidance includes the cost and benefit associated with continued optimization of our overall manufacturing environment as well as approximately $1 million in annual technology costs amortization associated with our Nexo acquisition. Capital expenditures for 2008 are expected to range from 17.5% to 18.5% of net revenues. Included in this estimate are the costs associated with the implementation of new PRP, product costing and HRIS applications together with enhancements to various systems used for operational insight and analysis. We expect that the full year 2008 EBITDA margin will range from 16 to 18% of 2008 net revenues and that the two year 2008 full year effective tax rate is expected to be 42%. Finally, for purposes of calculating full year diluted EPS we estimate that the weighted average common and potential common shares for 2008 will approximate 27.3 million.

Before I turn the discussion back to Jeff I’d like to remind you that our insights into financial performance will continue to develop throughout the year. As a result we will continue to revisit our financial guidance on subsequent earnings calls during 2008. With that, I thank you for your time today and look forward to meeting many of you in the days and weeks ahead. Now, I’ll turn it back to Jeff for some final comments.

Jeff

Before opening up the call to your questions I’d like to make some additional comments on our business outlook for 2008. We enter 2008 with very strong momentum from 2007 where we delivered record revenues, adjusted EBIDTA, customers, orders and average order value. In fact, we raised the low end of our revenue guidance to $245 million up from $240 with our new forecast for 2008 being $245 million to $255 million reflecting our returns on our investments in our brand, user experience, products, services, processes, technology and manufacturing capabilities. However, many market players have been talking about so called consumer headwinds resulting from a slower economy, reduced home prices and the mortgage and debt crisis and while no company is recession proof I do believe that since Shutterfly products and services are about memories and personal connections and how ASPs are affordable with intransient value as lasting keepsakes we are well positioned relative to other consumer discretionary spends.

As Mark said, our guidance incorporates our assessment of economic conditions as well as our agility and our flexibility in controlling costs to bring them in line with revenues. We remain focused on the long term and are committed to growing Shutterfly rapidly and profitably on a full year basis. We believe this approach maximizes the ultimate size of the Shutterfly franchise and thus long term shareholder returns.

With that I’ll open up the call to your questions.

Question-and-Answer Session

Operator

The question and answer session will be conducted electronically. (Operator Instructions) We’ll go first to Imran Khan with JP Morgan.

Imran Khan – JP Morgan Securities Inc.

Two questions, one specific to Q1 guidance. I think your fourth quarter revenue was up 48.5% year-over-year and your Q1 guidance on a high end is 35%. I’m trying to better understand, I know you talked about the economy slowdown, are you seeing an economy slowdown? Is that why you’re guiding such a deceleration in Q4 to Q1 growth rate on a year-over-year basis? Second question, if I look at the customer count and order growth rate but accelerated in the quarter but in average order size growth rate was only up 3%, is that because of promotion? Are you seeing a change in average buying behavior by the customers? Can you give us some color?

Jeff

Our Q1 guidance incorporates where we are within the first 30 days of the month. We’re seeing very healthy visitation, registration, uploads and sharing on the platform which is a sign of vitality and continued growth in the business. We’re seeing a little bit of trepidation on our customer’s part in then actually turning that into ecommerce transactions. But, remember in the quarter we still have two big holidays coming up, Valentine’s Day and Easter occurs in the first quarter of this year. So, I think what you’re seeing is us being prudent about the macroeconomic trends but still a very strong belief in the full year guidance of $245 to $255 million.

As it relates to AOB, there are a couple of things, one is we’re lapping a full year now of our new 12x12 and 8x8 customized photo books and then also we delivered significantly more on the top line in the fourth quarter and some of that was through additional promotions and merchandising on the site to get people to try cross categories. To get them to try a new photo book, to try out new designer cards and we believe once they touch them and feel them and purchase them then we’re going to be able to get downstream orders and increasing lifetime value from those customers.

Operator

We’ll take our next question from Yousseff Squali with Jeffries & Company.

Yousseff Squali – Jeffries & Company

A couple questions, first does your guidance contemplate a price cut on the print side of the business? And second, if I look at your sales and marketing year-on-year it kind of shows negative leverage in Q4 of 07 over Q406. Can you speak to that? Your customer acquisition went up a little bit. Can you kind of talk about is this kind of a mix of channels, some of the new channels that you’re trying out?

Jeff

Let me take the second one first Youssef. Sales and marketing, as we talked about we’re big believers in integrated marketing and using multiple levers and as we continue to expand into adjacent markets like scrapbooking and our social stationary we’re deploying different levers. For example, we increased our print level spend this quarter, we increased our spend in direct marketing our catalog, we saw very good ROI on both of those initiatives both to new customers as well as existing customers. We also have in the marketing mix now is Target and so as we sell products through Target they’re taking a share of that and so that’s another awareness building kind of campaign for us. So, our cost of acquisition continues to remain very low, our viral nature both through physical and electronic sharing, the PR mentions of over 3.8 billion impressions continue to drive healthy traffic and conversion on the website. So, it’s a bit of a mix of us sampling and promoting across categories so that we kind of lock people in to the full breadth of our assortment.

On the price cut, we haven’t announced a specific price cut but what we have said is that we’ve always maintained a significant premium to the market and Snapfish particularly, you saw a growth in prints that were very robust. In the fourth quarter prints grew at a healthy rate of 34% and for the full year we grew prints more than twice the industry average of 15 to 20%. So, even though we’ve always been the highest price our targeted customers care more about value. They want design, they want the fact that we don’t delete photos, we don’t down sample them, they want to be inspired through our community, they want ease of use and so they really come to us for the total value proposition rather than being price sensitive. We have a demonstrable success record of being able to maintain gross margins at the 54 to 56% level despite the price of prints declining even at a time when prints were a much larger percentage of our revenue. We feel comfortable that we’re going to be able to continue to leverage the investments in our brands to drive both high top line and bottom line and we’re taking up the full year guidance which is reflective of our belief in the winning formula.

Operator

We’ll take our next question from Kristine Koerber with JMP Securities.

Kristine Koerber – JMP Securities LLC

Let me ask the price cut question a different way. What would cause you to adjust your prices on the 4x6 prints?

Jeff

We’d look at it from a couple of angles. First is if we started seeing deceleration in both our existing customers and our new customer growth rates and we have some precursors to that. We see visitation, we see registration, we see upload, we see share, all the free components on our site, the activity there are precursors to actually purchasing, making people customers. So, if we started seeing us lose market share that would be one kind of indication. The second is we continuously are testing price elasticity in the marketplace and understanding where the optimal price point is not just on 4x6 prints but on a full kind of value of the customer in the first year and on a multiyear basis. Remember, we have prepaid print plans that are as low as $0.12 so $0.12 versus $0.09 we’re pretty close to Snapfish for customers who are very 4x6 centric.

We have a lot of data being an ecommerce company. We have a lot of experience doing this having gone through five or six industry price cuts on 4x6 prints over the eight or nine year industry history. We’re constantly balancing price versus adding new feature functionality versus being thoughtful about our targeted demographic versus our competition.

Kristine Koerber – JMP Securities LLC

Great. Second, would you consider letting up on your investment spending if business significantly slowed?

Mark

Absolutely. I think there is certainly plenty of opportunity to be flexible on our spending to keep it in line with our revenue growth whether its headcount or marketing spend or even technology development. So, that’s something that we would absolutely keep a focus on.

Jeff

Our strategy is growing as rapidly as possible but profitably on a annual basis remains intact and given that we’re in significant investment mode our levers and the agility to move those I think are greater than other companies who have kind of a built in fixed cost infrastructure versus being in hyper growth mode.

Kristine Koerber – JMP Securities LLC

Lastly, can you just talk a little bit more about the target relationship and you said you were working on refining some of your in store displays, etcetera. Can you maybe quantify what kind of volume you got during the quarter and what you’re doing in store that may be different? What’s worked or hasn’t worked?

Jeff

Sure. Let me start with the relationship is going very well and in Target we found a partner who is committed to the space who has the shared vision of customer centricity and design and innovation and is taking a multiyear approach to optimizing the relationship for both parties. If you look at kind of the ability to pick up at retail that benefitted us in the fourth quarter because it extended the shopping season past our tradition shipping cutoffs and allowed our customers to be able to walk into Target stores and get prints. So, that was a benefit.

When we talk about optimization, when you’re running retail you’re looking at where your displays are, what eye level they are, what is the call to action, what department they are in, should they be in crafts, should they be in scrapbooking, should they be in consumer electronics. So trying to optimize it if you will on Target’s behalf kind of revenue or profit per square footage, we look at what’s the message and the size in their circulars, we’re looking at our end caps versus our back caps and what’s the offer and how do we differentiate. So, it really comes down to kind of the art of retailing and this will be a continuous optimization process. The other thing is you roll out into over 1,000 stores you’re going to have a variety of execution. So we’re working on making sure that the execution is consistent, the quality is consistent with our brand and with Targets. So, coming out of our first full quarter of the relationship we’re very pleased with the results on both sides but we believe there’s upside for both parties as we continue to optimize it.

Kristine Koerber – JMP Securities LLC

Can you quantify though what kind of volume or customers you received a result?

Jeff

We’re not going to break out the specifics, it was fairly small given the size of our base business and the newness of the category. But, again it extended the holiday season particularly on the print side where you could pick up in retail and as we said all along the Target relationship in the early days is really about awareness. It’s about getting our brand out there, it’s about people touching a physical box and products and being able to see the quality and the uniqueness of these products. So, the way that we’re measuring it both on an ecommerce kind of conversion basis but also we look at aided and unaided brand awareness measures as well and on the awareness level the Target relationship is having a very nice impact.

Operator

We’ll take our next question from Aaron Kessler with Piper Jaffray.

Aaron Kessler – Piper Jaffray & Co.

A couple of questions guys, first on the gross margins I guess the midpoint of 08 guidance was slightly below for 07, I think the midpoint was 54 versus 55. I was just wondering if you could provide a little color on that? And, a follow up for Mark on the cap ex specific guidance of approximately $45 million for the year at the midpoint, I’m just trying to get a sense over the longer term how are you looking to increase efficiencies to the cap ex spend relative to the EBITDA amount?

Mark

I’ll take the first one on gross margins. One of the things that I alluded to in my script was that in connection with the acquisition of Nexo there’s a component of purchase price, about $1 million in the year that is amortizing over five years but, $1 million in 2008 so that is one thing that is contributing. The other is continued integration of the platform and a pretty full product road map. So, we think that is a manageable level and allows us to make some investments to optimize our total manufacturing capacity.

On cap ex, I think that the key thing to keep in mind is at the $245 to $255 million revenue level there’s pretty significant growth which will drive increases for lap equipment and the cost of site operations particularly in storage. But, the other big item this year is we are making some pretty sizeable investments in ERP an HRIS product costing system and improved capability in data warehousing and various analytics. So, these are things that will give us one, better decision making over the long term as well as scale and I would look at them certainly not the type of investments that would happen every year. Across the company though, there is a concerted effort to constantly look at every level of cap ex spending and find ways to optimize that spend and we’re going to continue to do that and maybe even redouble the effort.

Jeff

Just to add to Mark’s comment the other thing we’re going to do this year is significant new feature functionality to the website will roll out. You’ll see that over the next few quarters and we include our capitalized R&D in our cap ex numbers so dissimilar from other people who don’t include that so that is a reflection of the continuing investment in the user experience in our differentiation from the competition.

Aaron Kessler – Piper Jaffray & Co.

Just one follow up question, you’re clearly seeing a surge in popularity in digital photo albums, I’m wondering if that’s having any negative impact on the number of prints that people do? Also, is there an opportunity for you to maybe leverage that in terms of aligning yourselves with some digital photo albums and maybe selling that on the site as well?

Jeff

When we first launched our personalized publishing platform in August of 2006 there was a hypothesis that these photo books will become so popular people will stop printing. What we’ve seen is actually the entire appetite for social expression and memory preservation has grown. So, people are using them for different use occasions. So, while our personalized products and services grew 69% year-over-year our prints grew at a very healthy rate, more than 50%, almost 100% higher than the entire industry. So, for our customers, the ones that are attracted to us and our brand and our services and product offerings, this is something that’s important to them; keeping their memories and sharing them. They’re using prints to scrapbook, they’re using them to put on a refrigerator, they’re using them to frame them in their home and their office and they’re using photo books to tell their story in a longer kind of format and also photo books make wonderful gifts and it’s a wonderful way to be creative. We’re not seeing the cannibalization of growth rates. And the acceleration of growth in prints over the last year I think is a testament to the appetite for our products and services.

Operator

We’ll take our next question from Shawn Milne with Oppenheimer.

Shawn Milne – Oppenheimer & Co., Inc.

Just a couple, Jeff just to go back to the price cut questions, you talked about some trepidation from your customers in the first quarter. Can you define that to anything you’re seeing on the print side that may lead you to believe that Snapfish is having some impact? Or, maybe you could clear that comment up? Secondly, Mark I know you talked about amortization of the Nexo deal but I think you indicated there were some integration costs in the first quarter as well that were impacting EBITDA?

Jeff

I’ll take the first question and hand over the Nexo question to Mark. Based upon our new customer and our existing customer rates and the activity on the website, we are not seeing a loss of market share based upon Snapfish’s price cut. That is a very positive thing for us. I think what we’re seeing is again, pretty healthy growth we’re projecting for the full year in Q1 but, it’s hard not to turn on the TV and have all the talking heads scaring consumers that we’re entering into a recession or that we’re in a recession. So, I think given it’s a new year people are busy, the holidays are still upcoming, they just made a lot of photo books in the fourth quarter, utilizing a lot of our new services. There’s just a little bit of slowdown in the purchasing but we’re actually seeing very healthy rates of adoption of the platform. Snapfish is not having any impact to date. Very good leading indicators of activity on the website, us being cautious and prudent about the macroeconomic condition and we remain very confident about the future of the business and I think our full year of growth targets reflect that.

Mark

On integration cost I think there are a couple of components going on. One, just from a purchase accounting standpoint with the Nexo acquisition we’ve disclosed the approximate amount of just under $15 million. There is a component of that will be allocated to the cost for the value of their technology which will be amortized over five years, it’s about $5 million. There’s also a component that will relate to stock based compensation of about $4 million that will amortize over two years. The other thing from a systems standpoint we’ve been making a lot of investments in various enhancements to our platform that will continue that were ongoing in 2007 and will continue in 2008. The cost of these significant platform additions gets capitalized and the amortization of those amounts actually goes through cost of revenue. So, that is a couple of the areas that is impacting the clogged line.

In terms of systems, I mentioned ERP product costing, HRIS and analytic data warehousing environments. These are all things that I think every growing company when they have confidences in future, go through. We’re going through it this year. We think it’s the right time in our development and it will have an impact both in cap ex and on our operating expense lines.

Operator

We’ll take our next question from Brad Manuilow with American Technology Research.

Brad Manuilow – American Technology Research

Just to make sure I heard you guy correctly did you say that Q4 will make up a larger percentage of annual revenues and EBITDA going forward?

Mark

That’s correct. We think that there’s a lot of things that we’re doing to help improve the seasonality and we’re going to continue to do that, we’re making progress. But, we also expect to continue to add new users at a very rapid rate and that environment is likely to drive a slight increase in our Q4 seasonality this year.

Jeff

To add to Mark’s comments, if you look at what the Street’s 2008 by quarter forecasts are they are assuming a 200 to 300 basis point decline in the fourth quarter and they’re pushing that into the first three quarters. So, Q1 forecast on the Street was higher than our guidance and part of that is because of the assumption on seasonality. So, I think a good proxy for you guys as you’re building your models is to use the actual revenue by quarter in 2006 as a good model for how we think of the full year. That’s why we took up the bottom end of our range and for the full year we’re assuming its a little bit more back ended based upon some new products and services that we’re going to be rolling out than Street had modeled.

Shawn Milne – Oppenheimer & Co., Inc.

Just to follow up on your prior commentary about Q1 customer purchasing behavior, your guidance implies a slight acceleration in revenues throughout the year to get to your annual revenue growth guidance. I’m just wondering what gives you the conviction based on your commentary about Q1?

Jeff

I think it’s a couple of things, one is we’re very metrics driven in our ability to forecast is pretty sophisticated. We look at a combination of orders, customers, the average order value, we look at our product road map and when we have new feature functionality rolling out. We also look at holidays and where they’re falling and kind of the purchase behavior growth of those specific holiday in 07 over 06 and what we’re seeing is a little bit more spikiness around those holidays where people are starting to adopt our products as gift giving around those holiday seasons. We also recently launched our baby announcements, two weeks ago, our premium designer stationary. So, we’re modeling in that and future announcements on new innovations that we think will drive revenue acceleration throughout the year causing it to be a little bit more back loaded than 07.

Shawn Milne – Oppenheimer & Co., Inc.

If I could ask one last follow up, can you give us any insights on how depreciation, amortization should grow going forward? I assume it grows with cap ex but, is there any deviation from that going forward?

Mark

There’s no significant deviation and for the most part we’re buying the same types of equipment and software and they’re going over the same amortization depreciation periods. But, I think if you model cap ex and assume it is consistent, it should be a good proxy.

Operator

We’ll go next to Jeff Shelton with Natixis.

Jeffery Shelton – Natixis Bleichroeder, Inc.

The revenue mix in the fourth quarter was a little bit different than what I was expecting given that the print revenue growth actually accelerated on a sequential basis while the personalized decelerated. I guess the first question is was the mix in line with what you were expecting? And, for the second question, the behavior of both your existing and your new customers was that noticeably different in terms of what they purchased this fourth quarter over the fourth quarter of last year?

Jeff

Let me take the second question first because I think it informs the first question. As these markets are very large but very new and as customers become aware of what they can do with their memories beyond the 4x6 print we’re seeing their kind of first purchase behavior differ. Three years ago they were buying prints and today now they come in and they spend a couple of hundred dollars on a holiday card order, or they’re buying five or six calendars, or half a dozen photo books. So, that kind of traditional customer definition and kind of the activity enhanced the revenue and LPD of them is changing so there is no typical customer as you look over the last three years.

I think that’s a positive thing as people are becoming aware. Remember we talked about on the last call that only 6% of the 58 million households that have a digital camera and broadband connectively have yet purchased something in terms of personalized products and services. So, as that awareness continues to grow we expect that mix to shift. One of the things we found, not dissimilar from my experiences at other ecommerce companies is if we can get people to purchase across multiple product lines their lifetime value rises. So, some of that extra marketing and promotional and cross selling we did in the fourth quarter was aimed exactly at getting people, the print people to become photo book people, the photo book people to become card people and that virtual cycle continues to expand. So, you’ll see us make investments in cross sell and up sell to drive the ultimate size of the lifetime value of the customer.

Your first question was about expectations. The actual mix of personalized products and services against prints and then within those two sub categories was pretty in line with our forecast and our estimates for the quarter and for the full year.

Jeffery Shelton – Natixis Bleichroeder, Inc.

In the event that the economy weakens, do you see either the print or the personalized products being impacted more?

Jeff

Prints are obviously a lower ASP product. Photo book starts at $30 for a hardcover and goes up to $190 so you may see frequency of photo books change. But, the ASP is much larger than prints so outside of our business any consumer discretionary spend, the higher the ASP you would think there would be more price elasticity than the lower.

Jeffery Shelton – Natixis Bleichroeder, Inc.

Last question, comparing your first quarter guidance versus the first quarter of last year clearly revenues going to be up, you’re gross profit margins are going to be fairly similar so you’re gross profits are going to be up but, your adjusted EBITDA guidance was for $3 or $4 million less than it was last year. I’m just trying to reconcile what you’ve said with questions before this one about what particular buckets on the operating expense are going to be significantly higher than they were in the first quarter of last year?

Mark

We haven’t historically given guidance on a line-by-line basis or even at an operating margin but, I think generically and there’s a lot of investment that’s going on, on the platform side and on the marketing side of our business so we’re adding not only people but we’re adding different programs and features and functionality and I think that’s the bulk of where the costs are going. There is a component relating to ERP systems and so on that will hit G&A a little bit in Q1 but probably more so in Q2 and Q3.

Jeff

Even within the context of a potential slowing of the US economy these markets are very large, they are very early. Our cost of acquisition is fairly low. The lifetime value of our customers are very high. We’re the leading brand, we essentially have no debt, we have $126 million in the bank so we’re going to keep investing in this business in sales and marketing, in acquired customers, in product and engineers to build new feature functionality, in scaling the G&A in terms of systems so that we can be more sophisticated and handle the future growth that we’re anticipating. We’ll be thoughtful to map our expense and our investments against the revenue but we really to believe these early days of very enormous markets and that continuing to go after them to maximize long term shareholder value is absolutely the right approach.

Operator

There are no further questions. At this time I’d like to turn the call back over to Mr. Housenbold for any closing remarks.

Jeff

Thank you everyone for attending today and for your thoughtful questions. In closing, I was reflecting about where we were about a year and a half ago when we were on the IPO road show and what was our investment thesis for the company at that time versus today and they remain the same but have gotten stronger. Let me reiterate what those were: first, the markets for social expression and personal publishing are enormous and in the midst of transformation and we’re leading that transformation. Second, Shutterfly’s premium brand and our focus on delighting our customers are driving lasting benefits including a very loyal and enthusiastic customer base that increase with viral word of mouth referrals, sustainable premium pricing across all of our product categories, deeper customer trial and adoption across an expanding product line and growing repeat customer revenues. Third, our commitments to control our manufacturing and ongoing innovations are the keys to maintaining high quality while driving continuous efficiencies and improved margins. Fourth, Shutterfly continues to deliver an excellent track record of sustained execution which his demonstrated across all aspects of our operational and financial performance and throughout all 2007 when we delivered record revenues, adjusted EBTIDA, orders, customers and average order size.

When we went out public in September 2006 the book of business to get into the IPO was oversubscribed by a substantial amount, that was coming off the year of $54 million in revenue, today we’re guiding $245 to $255 million, nearly five times as great with a five straight quarters of outstanding excellence as a public company and 28 consecutive quarters as the company overall. So, I remain more optimistic about the future of this company and about the growth in the industry than I have ever been before. My management team and employees here will continue to execute against our strategy which is one of growing as profitably and as rapidly as possible but really focusing on long term shareholder maximization. With that, we look forward to updating you guys on our Q1 earnings call and seeing you out on the road. Thank you.

Operator

This does conclude today’s conference call. We appreciate your participation. You may disconnect at this time.

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Source: Shutterfly Q4 2007 Earnings Call Transcript
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