Shutterfly Inc. Q1 2008 Earnings Call Transcript

| About: Shutterfly, Inc. (SFLY)

Shutterfly Inc. (NASDAQ:SFLY)

Q1 2008 Earnings Call

April 30, 2008 5:00 p.m. ET


Judith McGarry - Director of IR

Jeff Housenbold - CEO

Mark Rubash - CFO


Aaron Kessler - Piper Jaffray

Youssef Squali - Jefferies

Kristine Koerber - JMP Securities

Troy Mastin - William Blair & Company

Imran Khan - J.P. Morgan

Shawn Milne - Oppenheimer

Matt Troy - Citi


Welcome everyone to the Shutterfly's first quarter 2008 Earnings Call. As a reminder, today's call is being recorded. I would now like to turn the conference over to Ms. Judith McGarry, Director of Investor Relations for Shutterfly. Please go ahead Ma’am

Judith McGarry

Thank you operator, good afternoon and welcome to Shutterfly's first quarter 2008 conference call. With us today are Jeff Housenbold, Chief Executive Officer of Shutterfly, and Mark Rubash, Chief Financial Officer. The press release detailing our results is available on, and an archived copy will be kept on our site. We also have released some visuals that we use as we go through the call.

Additionally, within a few hours we will release the 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

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 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 sections entitled risk factors in the company's latest quarterly report on Form 10-Q, and its 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 contains certain financial performance measures that are different from financial measures calculated in accordance with GAAP and may be different for calculations of measures made by other companies. A quantitative reconciliation of these non-GAAP financial measures to the most directly comparable GAAP financial measures have been include in this presentation and are available in our Q1 2008 earnings press release, which is posted on the Investor Relations section of our website at

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

Jeff Housenbold

Thanks Judith. Thank you all for joining us on today's call. Our agenda will start with the review of our investment thesis and key accomplishments for the first quarter. Then I will turn the call over to Mark to review our financial performance in detail and provide guidance for Q2 '08 and full year 2008. I will then provide some insights into our 2008 initiatives, and then we'll open up the call to Q&A. So let's get started.

Shutterfly delivered a very strong quarter. We grew revenues by 29% year-over-year and Q1 2008 marks the company's 29th consecutive quarter of year-over-year growth. Our growth in Q1 2008 was well ahead of the overall e-commerce growth rates of 17% as cited by Forrester Research.

During our Q4 full year 2007 earnings conference call on February 6, we discussed the macroeconomic environment and how some e-commerce companies were reporting the effects of an initial slow down in consumer spending resulting from a slowing economy. At that time all Shutterfly's leading indicators for orders and revenues, which include site visits, user registration, image uploads, and shares sent were quite robust, and they remained strong throughout each of the first three months of the quarter.

In fact, Mark will review these user engagement metrics in greater detail with you during his remarks, as we believe they offer useful insights into our overall performance for the quarter.

Yet despite strong year- over-year growth in user engagement metrics, the growth in orders for the first quarter was more modest; an indication that perhaps even our more affluent customer base is somewhat affected at least indirectly by this economy. We believe that our strong performance in Q1 provides additional validation that the five pillars of our investment thesis are as robust as ever.

To review the pillars first, the markets for social expression and personal publishing are enormous, evolving, and in the early days of significant transformation. Q1 customer engagement metrics reinforce our belief that the markets are early and that consumers are embracing Shutterfly as the premiere place to share and tell their stories.

Second, Shutterfly is the market leader with the premium brand and increasing brand awareness. Continued strong growth in our customer base and our overall market leadership position create tremendous advantages for us. We enjoy an expanding cycle of growing brands awareness in trial leading to strong customer loyalty, which then drives passionate, evangelism and further awareness of our brands. We believe this cycle ultimately results in increasing revenue.

Third, Shutterfly is relentlessly focused on continuous innovation with an expanding assortment of high quality products and unique services that connect our customers more closely to us. We remain intent on delighting our customers, evidenced by high repeat business from existing customers, which have consistently been in the 75% range of total revenues.

Fourth, we control our own manufacturing, which allows to us maintain high quality products, provide a high level of service, innovate quickly, differentiate, and drive continuous efficiencies and improve margins.

And lastly we have an experienced leadership team that has consistently demonstrated operational and financial discipline in executing our business model. So while it's clear that we are in the midst of the slower consumer spending environment, we remain very confident about the gross prospects of our business and of the overall market.

We believe we are doing the right things to strengthen and extend our franchise and increase our market leadership.

In fact, during economic slowdowns market leaders recognize and seize the opportunity to invest in strengthening their leadership position and that's exactly what Shutterfly is doing. Our approach is to continue making smart, well considered decisions that balance our short and long-term objectives. That means we are investing in products and services, in people, in processes, and in systems that will drive our long-term success and growth in the market. It also means closely managing our expenses and investments and adjusting to the realities of the current market. But as our Q1 2008 results show, we are able to make these adjustments rapidly and prudently.

Now I'd like to briefly review our Q1 accomplishments. In Q1 we extended our services offering with a launch of Shutterfly Gallery, a social network that leverages the power and enthusiasm of the viral Shutterfly community, and that enables customers to creatively inspire each other, by sharing their photo books online, and blogging about their experiences.

Shutterfly Gallery makes it even easier to create photo books in less time with the make one like this feature, and allows customers to copy posted photo books, and use the designs as templates for their own creations.

Initial response to Shutterfly Gallery has been fantastic. Customers have already posted thousands of photo books on the site, and the books are attracting hundreds of thousands of visitors. The community's desire to share their stories is infectious and inspiring. Our customers have created and posted books across many categories ranging from Gordon's First Body Book, which had more than 35,000 visitors, and Nancy's Yosemite Trip, which had 29,000 views, a book about single parent adoption, which caught the attention of more than 20,000 other Shutterfly members, the story of an angel, celebrating the life of a newborn who had passed away, to the 11,000 people who were inspired by Zenaida and Ruel's Wedding Book.

Shutterfly Gallery and our recent acquisition of Nexo are both part of a broader strategy to add compelling community features and services to the Shutterfly experience. We believe that these differentiated services can accelerate viral, cost-effective customer growth, increase e-commerce transaction, and increase customer retention.

On the products front in Q1, we introduced a new line of premium designer stationery for the baby market that enables parents to celebrate the arrival of their newborn with stylish announcements, invitations, and thank you notes. Shutterfly's exclusive designer card collection features fresh, unique styles that address parents many social stationery needs during the first year of their child's life with a sophisticated personal touch.

Overall we are very excited about the designer card category for several reasons. First, our customers have been asking for these products, and they are a natural extension to our premium brand and high quality social expression product line. Second, use occasions such as baby and wedding occur throughout the year, and offer customers more reasons to turn to Shutterfly.

Lastly, the social stationery market is highly fragmented where the many players have little online experience, inefficient supply chain, and varying degrees of quality. We believe our web experience, manufacturing capabilities, and premium brand, create comparative advantages. While still early days for this emerging market, customer response to our designer cards has exceeded our internal expectations.

From a marketing perspective Q1 2008 included both the Valentine's and Easter holidays. Based upon our earnings from the last year's Valentine's Day program, we launched integrated online advertising, direct mail, merchandising, and PR campaigns, to drive sales. We also created unique promotions to drive trial from newly acquired Sony, Target, and Yahoo! customers and to cross-sell photo book and cards to our existing customers. Despite an increasingly pessimistic consumer outlook on the economy, our Q1 holiday efforts produced solid results.

Our integrated marketing efforts are also driving increased consumer and press awareness. Recently we were featured on Martha Stewart’s TV show and by a number of leading consumer and business publications. Further bolstering our marketing initiatives was good progress with our strategic partners.

Following our success with Target during the Q4 holiday season, we are now testing opportunities with life occasions, such as baby and wedding, including Target's wedding registry, Club Wedd.

Building on our retail experience with Target, we launched in store tests with Borders, the 3.8 billion global book and entertainment retailer, and with Archiver's, the premiere scrapbooking retailer. The Archiver's relationship complements our newly announced efforts with CK Media, the leading publisher and authoritative voice in the scrapbooking community.

During the quarter we launched a number of marketing, design and educational initiatives with CK Media, that will provide the foundation for the further penetration into the scrapbooking market.

So that summarizes our investment thesis and key accomplishments for the first quarter. With that, I will turn the call over to Mark to review our financial performance in detail. Mark?

Mark Rubash

Thanks, Jeff. To begin my comments, I would also like to thank each of you for joining us on today's call and for your continuing interest and support of Shutterfly. As you may have noticed in reading today's earnings release, we've been working to bring an increased level of transparency and insight to our business and financial disclosures and I will try to do the same on today's call.

I'll start my comments with our assessment of the current macroeconomic environment followed by a new discussion of user engagement metrics, and our insights into the key drivers of this quarter's performance. I'll conclude with an update on our Q2 '08 and full year 2008 financial guidance and then turn it back o Jeff for his final comments and our Q&A session.

I think most of you would agree that we are in the midst of an economic downturn that is beginning to have a measurable impact on consumer discretionary spending. Main Street's buying power has diminished, as a result of declining property values, which are prompting lenders to cut off home equity lines. The overall credit crisis is limiting the availability of credit card borrowing and the US unemployment rate continues to rise.

Further pressuring consumers are the rapid increases in the cost of food and gasoline. And not surprising with the prospect of facing these type of economic realities, the University of Michigan consumer sentiment index recently declined to its lowest level in the past 26 years.

I summarize these economic headlines not to raise alarm, but because I believe they provide an essential context with which to evaluate our financial performance, both short term and long-term.

Consumers are being challenged economically and emotionally right now, which has and will likely continue to impact our revenue growth. Despite these external challenges, I want to echo Jeff, and say that we are executing on our strategy and continue to be very confident about our business and about the new and exciting markets for digital imaging and personal publishing products and services.

To further your understanding of our Q1 performance, we've decided to disclose a number of additional user engagement metrics this quarter that demonstrate the strength and vibrancy of the Shutterfly network. Revenue transactions are often preceded by site visits, user registrations, image uploads, and shares sent. And while net revenues were at the low ends of our guidance this quarter, we experienced very healthy accelerating year-over-year growth in visits at 32%, registrations at 32%, unique up-loaders at 41%, and shares sent at 28%.

As we mentioned on our February 6 call, with respect to early January activity, growth in customers and order volume lagged the growth rate of other engagement metrics, and produced quarterly year-over-year growth of 29%, and 26% respectively.

Because we experienced slower growth in order volumes across all product categories, we believe the declines are primarily explained by the macro-economy. Finally the progression of engagement metric and net revenues by month, followed a consistent seasonal pattern, with January showing the strongest growth, followed by February, and then March.

In Q1 we also saw clear patterns of strong customer demand, centered on the New Year's holiday, Valentine's Day and Easter. We believe this latter information is important and that it confirms that in difficult economic times, customers are turning to Shutterfly to celebrate key holiday occasion. So with the economic context and insight from our user engagement metrics in hand, let's now move through a discussion of our reported results starting with net revenues.

Net revenues for the quarter totaled $34.3 million, reflecting 29% year-over-year growth. The allocation of net revenues between new and existing customers was consistent with the prior year at 22% and 78% respectively. As expected, the year-over-year decline in order growth from 31% to 26% was primarily from our larger existing customer base. The improvement in average order size came largely from our newest customers, demonstrating the effectiveness of our programs to engage new customers in our full product assortment.

In terms of product mix net revenues from prints and personalized products and services, represented 46% and 54% respectively. In terms of growth rates, prints increased 17% year-over-year, and personalized products and services delivered 41% year-over-year growth.

Net revenues from 4×6 prints represented 29% of total net revenues, down slightly from 34% in the prior year, largely from effective cross-selling to our personalized products and services offering. In fact our award-winning photo book line continued to deliver the greatest net revenue contribution this quarter, as well as the highest year-over-year growth rate.

Moving to cost of net revenues and gross margin. We reported a gross margin of 48% down from the 51% reported in Q1 '07, and below the 50% low end of our financial guidance. The difference from our financial guidance is attributed primarily to two factors. First, we made a decision to accelerate a program to upgrade certain manufacturing equipment, by trading in older equipment, and purchasing units leased during Q4. To take advantage of this significant pricing opportunity, we incurred additional rental and depreciation expense during the quarter.

The balance resulted from an increased volume of product promotions, centered on the Valentine's Day and Easter holidays. These two cost increases, together with the added cost of running two plants this year, were substantially offset by increased utilization of our Charlotte plant, realized improvements in labor and shipping costs, and from negotiated improvements in certain materials costs.

Technology and development costs totaled $9.2 million for the quarter, and includes year-over-year increases of $1.4 million for depreciation, amortization and stock-based compensation. Excluding these amounts are technology and development spending, increased $1.9 million or 33% from the prior year. We believe that continuing to deliver the most feature rich, and easy to use products and services, to our targeted markets, is the right strategy, and we are very excited about our product road map for 2008 and beyond.

Continuing down the income statement, sales and marketing costs totaled $8.1 million in the quarter, representing 23% of net revenues, versus 19% of net revenues in Q1 '07. The year-over-year increase reflects continued investments in product marketing, merchandising, and customer marketing staff, together with volume related growth, and outbound marketing spent.

Our costs per new customer acquisition in Q1 '08 increased modestly from Q1 '07 level but remain below $12. Historically we have experienced lower cost per new user in the first three calendar quarters, and higher costs in Q4, when there is greater competition for consumer attention.

General and administration expenses for the quarter totaled $7.6 million, excluding credit card fees, which vary with revenue volumes, G&A expense was 19% of net revenues, consistent with the prior year. The cost increase from Q1 '07 results primarily from increased staffing to support the size and complexity of the company, higher legal costs, and certain costs associated with our ERP systems implementation.

Offsetting these Q1 costs was the receipt of the first annual installment from a three-year, multi-million dollar intellectual property licensing agreement with American Greetings. We will recognize the remaining two installments under the agreement in Q1 of 2009, and Q1 of 2010 respectively.

As we have disclosed previously Shutterfly is one of the pioneering companies in the field of online, digital photo management, processing, and printing, and has a portfolio of 23 issued patents, and 30 patent applications pending. The license with American Greetings represents the first transaction from our intellectual property monetization strategy.

Continuing the discussion, adjusted EBITDA for the quarter was a loss of $700,000. Significantly better than our guidance, of a loss ranging from $1.8 million to $2.3 million. This EBITDA improvement resulted from effective cross company efforts to manage our cost structure in line with our revenue growth, together with the incremental benefit from the license agreement with American Greetings.

The effective tax rate for the quarter was 49%, higher than our guidance as a result of lower quarterly pretax profit, and elimination of 2008 research and development credits from our full year forecast. As a reminder please note that our cash tax rate continues to be extremely low, due to the availability of net operating loss benefits, and that our GAAP tax rate is very sensitive to changes, in either pretax income or permanent differences such as R&D tax credit.

So to bring this discussion to the bottom line, on a GAAP basis our net loss for the quarter totaled $3.6 million or $0.15 per share. Shares used to compute EPS for the quarter, totaled $24.9 million.

To finalize my comments on the quarter, I will now provide additional insight on our capital expenditures, and on our cash, investment, and liquidity situation. Capital Expenditures during the quarter totaled $9.2 million, which included $5.9 million for technology related equipment and software, $2 million for print, manufacturing and office equipment, and $1.3 million in capitalized software development cost. Except for the early purchase of manufacturing equipment mentioned previously, all amounts are consistent with our expectations.

Cash and investments at March 31, totaled $92.6 million, composed of $42.8 million in liquid cash and cash equivalents, and $49.8 million representing the carrying amount for our student loan backed auction rate securities. Due primarily to the recent liquidity failure in Q1, we have recognized a temporary impairment of $2.5 million, which is reflected net of tax on the balance sheet as a component of other comprehensive income.

Like other auction rate holders, we do not have clear visibility on how long the lack of liquidity will last, but we can confirm that all of our securities continue to be AAA rated, that 95% of the underlying student loans are guaranteed by the Federal Family Education Loan program, and that we continue to receive interest payments on schedule.

Regarding our cash resources we are confident that the $42.8 million in available liquid securities is more than adequate to meet our current and future operating cash requirements. To further ensure that we have full strategic flexibility, while the auction rate markets are being resolved, we have supplemented these liquid resources with a $20 million, 364 day revolving line of credit with J.P. Morgan.

To complete my discussion I would now like to summarize our outlook for Q2, and the full year 2008, together with some additional insight on the underlying assumptions. Based primarily on our observations from Q1, and the first few weeks of Q2, we expect to see continued year-over-year strength in core user engagement metrics, but slower growth in terms of orders and net revenue. We also expect that revenue activity will continue to be strongest around the traditional holidays, with more dampened activity during the intervening periods.

And finally since the majority of our net revenues and all of our operating profits have historically been generated in Q4, we expect that our actual full year results will be heavily dependent on the economic environment in the second half of this year.

With respect to our manufacturing capacity, we believe that we currently have sufficient planned capacity to meet customer demand for the balance of 2008. As a result, we have determined that an additional west region manufacturing facility will not be required until Q1 of 2009. To bring up a new facility in this time frame, will require some operating and Capital Expenditures in the latter part of this year, but the majority of these costs will be deferred until next year.

In terms of our operating cost structure we will continue the course of making strategic investments at our product and service offering, the quality of our marketing operations, and the strength of our systems processes and people. We believe that these investments appropriately balance both short term and long-term opportunities, and that they can be made in a way that maintains our historical levels of profitability.

And finally we are expanding the depth of our financial guidance by introducing expectations for GAAP and non-GAAP operating income, margins, and earnings per share. We plan to limit the differences between GAAP and non-GAAP results, to acquisition related charges and amortization, stock-based compensation, and the related income tax effects of such items. We believe that supplementing the evaluation of our financial performance with these measures will enable a more comprehensive understanding of our business.

So now starting with Q2 '08. We expect net revenues to range from $35 million to $38 million, which reflects year-over-year growth of approximately 17% to 27%.

We expect our GAAP gross profit margin to range from 44% to 46% of net revenues, and our non-GAAP gross profit margin to range from 46% to 48%. We expect our GAAP operating loss to range from $11 million to $13 million, resulting in GAAP operating loss margins between approximately 29% and 37%. We expect our non-GAAP operating loss to range from $8 million to $10 million, resulting in non-GAAP operating loss margins between approximately 22% and 29%.

We expect our adjusted EBITDA will range between a loss of $2.4 million and a loss of $4.3 million. We expect our GAAP effective tax rate to range between 49% and 78%, and our non-GAAP effective tax rate to range between 38% and 39%. We expect the GAAP net loss per share to range from a loss of $0.11 to a loss of $0.21, and the non-GAAP loss per share to range from a net loss of $0.19 to a net loss of $0.24. For purposes of calculating the net loss per share, the weighted-average common shares are expected to approximate 25.1 million.

Turning now to the full year 2008. We now estimate that net revenues will total between $225 million, and $245 million, reflecting year-over-year increases, ranging from 21% to 31%. We expect the full year GAAP gross profit margin to range from 52% to 54% of net revenues, and our non-GAAP gross profit margin to range from 53% to 55% of net revenues.

We expect that our GAAP operating income will range from a loss of $1 million, to income of $8 million, reflecting full year GAAP operating margins from a loss of 1%, to income of 3%. We expect that our non-GAAP operating income will range from $10 million to $19 million with non-GAAP operating margins of 4% to 8%. We expect that full year EBITDA margin will range from 16% to 18% of net revenues.

The 2008 full year GAAP effective tax rate is expected to range from 49% to 78%, and the 2008 full year non-GAAP effective tax rate is expected to range from 38% to 39%. For purposes of calculating full year GAAP and non-GAAP diluted earnings per share, we estimate that the weighted-average common and potential common shares will approximate 27.2 million. We expect the full year 2008 GAAP net income per share to range from $0.01 to $0.20, and the non-GAAP income per share to range from $0.30 to $0.50. And finally, we expect that 2008 capital expenditures will be approximately 16.5% of net revenues.

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. So with that, I thank you for your time today, and look forward to speaking with many of you in the days and weeks ahead. Now, I will turn the discussion back to Jeff, for some final comments. Jeff?

Jeff Housenbold

Thanks Mark. Before, we open the call to your questions I'd like to highlight our operational and financial goals for the remainder of 2008. Since, we believe that our addressable markets are very large, and in the early days of penetration and transformation, we will continue to make smart investments for the long-term success and growth.

As the market leader with a strong balance sheet, and the team to drive continued strong execution, we have an opportunity to strengthen our franchise even further, by focusing on delivering excellence across all areas of our business. And by prioritizing our efforts towards increasing revenue, margins, and free cash flow.

During the next several quarters we will launch key new services, including; an expanding array of community features, such as the first phase of our next-generation sharing capabilities that leverage our recent acquisition of Nexo, and further enhancements to Shutterfly Gallery.

A redesign of our website that will transition user activity from a print center paradigm, to a creation and story telling focus, improvements in usability such as new uploading and address book tools. Plans for the new product innovations in 2008 include new high-end products, such as our new line of social stationery, new products to share and preserve memories, and product enhancements, such as our new padded and leather photo book covers, and a deeper assortment of design content to address our customers need for all use occasions and life events throughout the year.

We also intend to further optimize e-commerce funnels that drive increased visited order conversions, through expanded use occasions, increased product trial, and cross-sell and up-sell programs. For example, our recent enhancements to the photo book creation process, including adding live chat, along with the make one like this feature, and Gallery, are aimed at increasing photo book sell through. And our new expansion into the scrapbooking market, and our new wedding micro-site, are good examples of how we are increasing share of wallet.

The objective of all these activities is to drive revenue growth by increasing the number of transacting customers, the number of transactions per customer per year, and the average order value per transaction. In addition to our top line growth initiatives, we will continue to focus on expense management, and return on investment, in the following areas. For example, we have already begun to see pay-offs in productivity, and time to market from our investments in re-architecting our platform, and in improved engineering productivity.

On the marketing front, Mark already mentioned that our new customer acquisition costs remained low, as we continued to benefit from high word of mouth referrals, and high customer repeat rates, which are generated by our investments in brand, user experience, customer service, and manufacturing innovations. And we believe that the general and administrative costs will continue to improve, as we get leverage from this years ERP investments, and from last year's SOX compliance efforts.

We believe that the combination of continuous products and service innovation to drive top line revenue growth, plus an ongoing focus on delighting customers with great support and service, along with relentless focus on managing expenses, will strengthen the Shutterfly franchise in 2008 and beyond.

In addition, our focused efforts in 2008 should yield improvements to free cash flow, by reducing capital expenditures, especially in the following areas. Improving manufacturing throughput through proprietary process improvement, enhanced operator training in close collaboration with Xerox and HP R&D teams, our new hardware, selective outsourcing to strategic partners to reduce Q4 capacity peaks, and enhancement to our storage architecture that will lower our cost per image.

So that summarizes our prepared remarks today. Thanks for your time. Operator, at this time we will open up the call for questions.

Question-and-Answer Session


(Operator Instructions) And we will first here from Aaron Kessler, with Piper Jaffray.

Aaron Kessler - Piper Jaffray

Hi guys, a couple questions. First, any update, may be on how the business is progressing through April? And also, are you turning to more promotions to try to may be offset some of the conversion rates that you are seeing on the site? And one or two follow up questions.

Jeff Housenbold

Great. Thanks, Aaron. Without specifics on how April is going, let me talk a little bit about typically how the first quarter comes in. Mark talked about January was the strongest, followed by February and March, where February and March typically are about equal to each other, and we saw that consistent this year as well.

And then for the rest of the year, we typically see increasing revenue month by month for the rest of the year. We've seen a consistent pattern in April, as we have in the first three quarters, and our guidance for the full year reflects our understanding and visibility through the first four months of the year.

As it relates to promotions, we did a few more promotions in the first quarter, falling into two buckets. The first was trying to do targeted, one to one marketing for the customers that we acquired through the Yahoo! and Sony, shutting down of their sites, and migration to Shutterfly, and then also the customers that we got through the Target relationship. So we did a little more promotion there, to try to get people exposed to the broader product suite that we have, versus those sites that have closed down.

And then secondly, we were trying to drive additional cross-sell and up-sell particularly to our photo books, and our cards, to our existing customers for both the Easter and the Valentine's Day holidays.

But I wouldn't characterize that we did anything extraordinary, or heavy discounting or promotions, because our customers, our customers don't typically respond to promotions in the way of, say lower economically characterized customers would.

Aaron Kessler - Piper Jaffray

And as quickly on your print revenues, do you feel the slower growth is that more due to the macroeconomic issues, or are you seeing any pressure from competitive pricing?

Jeff Housenbold

We are not seeing pressure from competitive pricing. Keep in mind that our engagement metrics were very strong; visits were up 32%, regis. up 32%, and image uploaded is 41%, and shares 28%, and for example, the visits, if you look over the last three years, this first quarter's visits were up nearly 70%, over that three-year average.

So we are getting lots of customers coming. We didn't see any particular weakness across any of the print products, 4×6 and the rest of the products, were kind of fairly in line, indicating to us, that this is largely a macroeconomic issue, and not a competitive one.

Aaron Kessler - Piper Jaffray

Great. Thank you.


And we will hear from Youssef Squali, with Jeffries.

Youssef Squali - Jefferies

Thank you very much, Youssef Squali. On the 4×6, have you guys done any tests to see the elasticity of that product, so it should drop it down to $0.15, or something, could you reaccelerate that 17% growth?

And second, on your Q2 guidance, it looks like the midpoint about 22% versus about 52% last year. I know you've talked about engagement metrics, but how much of that slow down could potentially not be related to the economy, but may be the segment getting a little more mature, and maybe even competition in the photo book segments starting to intensify?

Jeff Housenbold

Great. Let me take the first, and I'll have Mark answer the second question. On the 4×6 prints, we always are doing elasticity testing to our install base, and we can do that kind of in a one-to-one way, instead of having to do it site wide, and so we get pretty good visibility as to where the leverage is, driving either profitability or top line revenue.

And we have not cut prices in response to Snapfish, and keep in mind we grew at 34% our print business for the full year of '07, versus the industry average at about 15%. Our planned sales continue to grow healthily, which locks in our customers to higher share of wallet for the entire year.

And our customers tend to be engaging with us, even on their first order now, more with personalized products and services than ever before. So the increase in average order value is actually driven by our new customers, more so than our existing customers, indicating to us that there's not an immediate need to lower the price of 4×6 prints.

Mark Rubash

Hi, Youssef. Would you repeat your question again on the guidance?

Youssef Squali - Jefferies

Yes, just trying to figure out how much of the decelerating growth from, again 52% last year to low 20s this year, could in fact be driven by factors more than just the economy, i.e., maybe maturation of some of the segments, or just the competitive landscape intensifying a bit?

Mark Rubash

I think if it was competitive we probably would see it more specifically in some of the different product areas, and when we look at the growth rates compared to our internal estimates, and compared to last year, it's a very consistent type of slowdown, and that's what really gets me focused on the fact that this is a more macro issue at play.

And as Jeff said when you look at the engagement on the site, in terms of visitors coming, registrations, and so on, if you look at the splits between new and existing customers, everything feels in line, and when you map out the trajectories from the last three years, all of the patterns actually look quite normal, other than just a dampened response.

So we've always operated in an environment with pretty intense competition. We haven't seen anything in terms of growth rates that are significantly different in terms of 4×6. So I think there's a hypothesis, but I don't think we have any data that really tells us that, at this point.

Youssef Squali - Jefferies

And lastly, on the gross margin guidance for, again Q2, 44% to 46%. Is there anything else going on there outside of just kind of negative scale, or negative leverage, out of the lower than expected top line?

Mark Rubash

No, I think it's really the combination of a number of things at play. One is, for sure we have two plants that we are carrying this year. There are some increases that are not huge, but they are measurable in terms of shipping rate increases coming in Q2. And there's also a seasonal variation in mix cross products that contributes to the softer margins, gross margin level in the Q2, Q3 time frame, versus Q4.

Youssef Squali - Jefferies

Okay. Thanks a lot.


(Operator Instructions) Now we'll hear from Kristine Koerber, with JMP Securities.

Kristine Koerber - JMP Securities

Yeah. Hi, a couple of questions. First of all, looking at your top line guidance, I know its back end loaded and primarily in the fourth quarter. And given the fact that visibility is limited, I'm just trying to figure out how much conservatism is in your guidance, especially given the fact that we are looking out to fourth quarter at this point. At a macro level things may get worse.

Mark Rubash

Yeah, I would say I'm not trying to be conservative or aggressive with the guidance this quarter. What I'm really trying to do is be thoughtful with respect to what's happening around the economy. If you go from the midpoint of our prior guidance, to the midpoint of our current guidance, it's about a 6% decline.

Similarly if you go from midpoint down 5%, you get to the low end of the guidance. And what we do have under our belt at this point is, we have all of the first quarter with a couple of key holidays, as well as the first month of Q2. That gives us some sense of how our customer base, and potential new customers, are faring in the current environment.

So I would say that one of the reasons we widened the range is because of the fact that we have significant portion of the revenue in Q4, and I believe that the success in Q4 is going to be very heavily determined by the strength of the economy, and the sentiment of the consumer. There's a degree of sensitivity around our mid-point of this guidance.

Jeff Housenbold

Yeah. And just to add to that Kristine, Mark made in his comments, that we saw people come out for the holidays, Valentine's Day and Easter very strongly, with more dampened commerce transactions in the non-holiday time.

So we remain confident that even in a downturn, people are going to come out and want to engage, and giving gifts for Christmas, and also staying in touch through greetings cards around the holiday season.

Kristine Koerber - JMP Securities

Okay. That's helpful. And then, as far as your capital expenditures, I'm trying to get an idea as to what the base level of the CapEx is, kind of the maintenance CapEx going forward.

And as you look out to '09, it sounds like you're pushing a west coast facility out into '09. How much should we kind of factor into our expense line as far as a new facility? How much would that cost?

Mark Rubash

Yeah. In terms of the capital portion of a new facility, it's probably in the $3 million range for total CapEx. The actual leasehold improvements for our plant are not overly significant, and the equipment that would go into the plant is all based on the volume needs at the time. So it's not a huge amount.

We aren't giving, obviously 2009 CapEx guidance, but I think a couple things to keep in mind this year, one is we are making some fairly significant investments on the platform, in terms of new features and functionality, so we will likely hit a career high in terms of capitalized software costs this year.

We are also spending $3 million to $5 million this year for ERP and other systems enhancements that would not be recurring. So I think you have to look to where we've been historically, factor in the cost of an incremental plant next year, and then probably modify for the things that aren't recurring on a steady state.

Jeff Housenbold

So if you look at the reduction from our previous guidance of 17.5, to 18.5, to 16.5, part of that is pushed out to next year, but part of that is reflecting the leverage we are getting through our new storage architecture, through the adoption of next-generation printing presses, which have higher throughput, and from our process improvements.

As well as some additional strategic outsourcing to third-parties that will dampen the need for us to have to buy that next machine, because we'll be able to outsource anything that's over kind of our run rate internally, to a third party. So we get to move our buffer stock if you will, off of our balance sheet, onto someone else's balance sheet.

Kristine Koerber - JMP Securities

Okay. Great. Thank you.


And now we'll hear from Troy Mastin, with William Blair & Company.

Troy Mastin - William Blair & Company

Thanks, good afternoon. The first one is very easy, CapEx in the quarter, I thought you said 9.2 in your remarks, but when I look at the cash flow statement it looks like it's lower than that. Can you give me the number?

Mark Rubash

Yeah. The cash flow number is the actual cash going out the door. The balance is capitalized software, which would be a non-cash component of what we've historically reported as total CapEx.

Troy Mastin - William Blair & Company

And so 9.2 is the right number?

Mark Rubash


Troy Mastin - William Blair & Company

Okay. Good. And then, you mentioned this licensing agreement with American Greetings. Help me understand where this hits on the P&L? I thought you made reference to it in regards to a cost line item, and some idea of what the magnitude is?

Mark Rubash

Yeah. In terms of the P&L geography, it's recorded as a credit to G&A expense. The SEC has a particularly strong point of view of licensing agreements that aren't part of your primary business activity, should not be reported as revenue. Because we have an active intellectual property program, and those costs are reflected in G&A, the most appropriate accounting is to offset any licensing income, or cash, as an offset to those costs.

Troy Mastin - William Blair & Company

Okay. And it's just this quarter for the year, and then will happen in subsequent years in the first quarter, correct?

Mark Rubash

Correct. The agreement calls for three annual installments for the total license fee, and those will happen in Q1-- it happened in Q1 this year, and second install will be Q1 next year, and then Q1 2010.

Jeff Housenbold

And we are excited about the cross licensing with American Greetings because we've been working on an intellectual property strategy, and this is the first clear sign of monetization of our investments in our IP. So, we believe this license opportunity sets the stage up for the possibility for further ones in the future.

Troy Mastin - William Blair & Company

In terms of magnitude, and whether this is contemplated in your guidance?

Jeff Housenbold

For confidentiality reasons we can't disclose the specific numbers, but the anticipated receipts, since it was in Q1, is reflective in our overall full year guidance, and we will reflect those anticipated payments next year when we provide full year '09 guidance later in the year.

Troy Mastin - William Blair & Company

I'm really referring to whether it was in the first quarter guidance or not?

Mark Rubash

It was considered in the first quarter guidance, yes.

Troy Mastin - William Blair & Company

Okay. Great. That answers my G&A question. The next question is really about margins, and I guess I would expect that this business in a slowing revenue growth environment would yield higher operating margins. It doesn't look like that will be the case this year on either a GAAP or an adjusted basis. So, if you could give maybe some color there, as to why maybe we don't see a little more flow through in a slowing revenue growth environment, and what it will take when -- before we start to see that sort of flow through?

Mark Rubash

In terms of what flow through flows through, I don't think there's anything naturally that would flow through just from a slower growth rate. Right now, we believe that the slowing growth rate is largely, maybe entirely attributed to a very difficult economy. We don't believe that the long-term market opportunities have diminished at all.

So for that reason, what we are doing is trying to be, one, very focused on our spending, putting it into the products and the marketing programs that will actually build the franchise. And making sure we are not spending money that won't have a return. So, we are making investments, but maintaining our historical margin structure.

Jeff Housenbold

And then you would have seen some leverage in G&A this year from the benefits of SOX compliance last year, but as Mark said we are investing for the future and so our 3 million to 5 million investment in our ERP this year, which will set us up for the future, is flowing through G&A as well.

Troy Mastin - William Blair & Company

Okay. And then finally I just want to confirm that your higher revenue guidance was all what would be now on your current revenue guidance as GAAP, correct, with the exception of adjusted EBITDA obviously?

Mark Rubash

That's correct.

Troy Mastin - William Blair & Company

Okay. Thanks.


Now we'll hear from Imran Khan with J.P. Morgan.

Imran Khan - J.P. Morgan

Yes, hi, thank you for taking my questions, and I apologize if any of these questions were asked before because I was bouncing around two calls. A couple of questions. First, I was trying to get a sense like have you seen any material change in the customer acquisition cost because of the macroeconomic environment?

Second question is the print growth rate decelerated quite a bit. Any plan to change pricing on that vertical? And the third and the last one is, are you still considering opening up a third facility in the west? Thank you.

Mark Rubash

I will take the first one and the last one, and let Jeff talk about the middle one. In terms of customer acquisition costs, no, we actually saw very consistent costs for Q1 this quarter. There was probably a slight uptick on a year-over-year basis, but still below a $12 that we've talked about historically.

And as I mentioned in my script, we typically see the most efficient acquisition costs in Q1 through Q3, and they do increase in Q4, when there's more competition for consumer attention.

And as far as a third manufacturing facility, we have decided that we will not need to add another plant this year, but we will plan to add one in the first quarter of next year, with a goal of having it operational in time for the Mother's Day holiday. So that will entail a small amount of operating and capital to get started, but no significant build out in 2008.

Jeff Housenbold

As it relates to the print business, Imran, in the call we covered that we don't believe this is a competitive issue, reflected in the deceleration but rather one that's macroeconomic. When we look at all the different print options from wallet all the way to our jumbo 20×30, we see almost an exact shift in the growth rates across the entire product line. And those other skews aren't facing any competitive pressure in terms of pricing.

So that along with our user engagement metrics in which we saw almost 70% increase over a three-year average in business and significant increases year-over-year in the engagement metrics, that plus our new customers, their AOS and AOB were increasing throughout the first quarter gives us strong confidence that our investments in brand and products and services continue to attract customers at a low cost, and that our high customer captivity and loyalty is reflected in the percentage of revenue from the existing customers. So, we think it's largely a macroeconomic, not a competitive one and not an issue around prices on 4×6.

Imran Khan - J.P. Morgan

Got it. Thank you.


Moving on then, we'll hear from Shawn Milne with Oppenheimer.

Shawn Milne - Oppenheimer

Thank you. Just to go back to some of the guidance questions. Can you quantify, Mark, what the Easter shift meant for adding to the growth rate in the first quarter and potentially impacting your second quarter guidance? And then I think, I know you tried to answer it on the last question, but can I ask specifically, is a 4×6 price cut in your current guidance for the balance of the year?

Mark Rubash

I don't have a number on exactly what was derived from the Easter holiday, but what I can say is that if you look at what happened around Easter this year, last year, and the year before, in each year the amount of activity, order and revenue activity increased in terms of intensity.

So even though there was slower order and revenue growth leading into the holidays, when we got to those holidays, we actually saw a very, very strong year-over-year performance around the holidays.

So when you look at -- when we looked at our long-term guidance, one of the things that we -- ways we try to triangulate is just different hypotheses about what a growth rate could be around the key holidays, with more dampened or lower levels in between.

And based on that, together with all of our other methodologies for building a forecast, that's where we ended up. And it's -- I think for me the positive was that the engagement metrics tell us that we are growing the customer franchise at a very healthy rate. The two holidays that happened in Q1 tell us that that larger customer base despite a tough economic environment still came out in a big way for those holidays on Shutterfly.

Shawn Milne - Oppenheimer

Just in terms of the response previously were you planned on not having an immediate cut in 4×6 print pricing? Can we ask if it's baked in the guidance?

Jeff Housenbold

We are currently not contemplating an immediate price cut and based upon what we think about -- in terms of our response to competitive actions, are based into our guidance for the full year.

You also asked about Q2 guidance, and obviously Easter was in last year's numbers, so that when you look on a year-on-year comp basis that is part of the reason why Q2 growth rates are slightly moderated.

Shawn Milne - Oppenheimer

Right. Well, that's what we were trying to ask. If you could quantify that, that would be helpful.

Lastly, in terms of promotional activity, you talked around having promotions around Valentine's and Easter. We certainly get the targeted e-mails in her in-box. Is that your effort to drive a better pricing message to consumers rather than a wholesale price cut? I'm just trying to understand the difference.

Jeff Housenbold

Yes, part of our strategy is to figure out on a one-to-one marketing basis, how we can get the greatest yield out of the different segments of our customers. When we do that, e-mail is a large part of that, but we also do that through certain partners. For example, an Amazon customer might receive a different promotional offer than someone who comes through Target or David's Bridal.

So, we look at what is the lifetime value of the different customer segments. We look at their transactional behavior, we do a psychographic and a demographic overlay, and we try to segment customers through various promotional activities based upon their relative scoring against an internal reach frequency monetization scheme. So, that's a more effective and a higher productivity approach than just a cut to the price.

Shawn Milne - Oppenheimer

Okay. Thank you.


Now, we'll hear from Jeff Shelton with Natexis. Mr. Shelton, your line is open. Moving on, we'll go to Matt Troy with Citi.

Matt Troy - Citi

Thanks. I was wondering if we could attack the capital question from another perspective or at least the utilization question. The business model is, as you've acknowledged, heavily skewed towards the back half of the year. I realize you are trying to drive and cultivate new business streams to create more of an annuity through the full year. I was wondering if you've evaluated more structural alternatives.

If I look at other business models, VistaPrint is certainly successful in their little niche of the market, and if I look at your product breath, your technology, your infrastructure, your fulfillment capability, doing something like a business to business marketing collateral type service, wouldn't I imagine be a big capital investment or a big technology investment, not just focused on that one business model? But, have you thought about or are you examining other alternatives using your existing infrastructure to more structurally improve utilization in quarter’s one through three?

Jeff Housenbold

We are, Troy -- Matt, sorry. We are looking at all different alternatives and having a number of conversations on ways we can more efficiently utilize our excess capacity, particularly in the first three quarters. And part of that challenge is finding businesses that have a counter seasonal because of lot of the marketing collateral they want to sell in the fourth quarter as well. That's a big peak business for many other industries.

And so, we don't want to layer on a business that optimizes somewhat the first three quarters, but then exasperates the issue in the fourth quarter. We are having a number of conversations. It's part of our strategic roadmap to be able to get greater efficiency and return on our assets.

Matt Troy - Citi

The second question would be -- and the numbers we track in terms of where people are actually printing the photo products and collateral, certainly the pure web-based model is still the fastest growing but retail in the last 12 months to 18 months has certainly picked up. The ability to get these more robust photo products and personally publish items at retail is a growth category.

I was wondering if you had discussion with retailers. I know you talked about Target and Borders, but is it becoming a more frequent conversation with retailers? Are you being approached by more retailers? And do you think that a more robust or broader retail strategy will be key for you folks going forward over the next two to three years? Thanks.

Jeff Housenbold

First, we we've been approached by lots and lots of players because of our unique capabilities on web experience, our brand and the quality of our products and the ability to manufacture.

So, we've had conversations with many players, and as we announced back in midpoint of last year, Target was the first foray for us into retail. Given their overlapping customer base from socio-economic, from a propensity for designs and fashion, and caring about value and not just price, we've extended based upon the learnings from our Target relationship our retail presence with Archiver's and Borders this quarter. And so we continue to test retail as a channel and look at the overall profitability, and the strategic importance of that channel.

While the retailers are starting to add the ability to do some limited personalized products and services in-store, those capabilities are still very limited and the quality differential is demonstrable.

So, we don't feel that our targeted demographic, who cares about quality and brand, are making a transition at all, and our internal surveys show that they understand the difference of a Shutterfly Photo Book versus those they can get at their local photo shop or retailer.

So, we think it's actually good that the retailers are entering this part of business because it's growing an overall awareness, and as we've said, that's really our largest competitive challenge is there's only been about 6% penetration of the addressable market into the personalized products and services.

So, as more and more people become aware, we think our high-end quality and differentiated service will draw the profitable customers our way.

Matt Troy - Citi

Excellent. Thanks for the time, guys.

Jeff Housenbold

Thank you.


And there are no further questions. Mr. Housenbold. I will turn it back to you for any closing or additional remarks.

Jeff Housenbold

Great, I want to thank everyone for joining our first quarter call. We are very pleased with our 29% revenue growth in the first quarter. We are excited about the new products and services, like Shutterfly Gallery that we launched in the first quarter, and the upcoming enhancements to our services and our products throughout the rest of the year, and we look forward to updating you on our progress on the Q2 call. Thank you.


That does conclude our conference for today. Thank you for your participation. Have a pleasant day. You may disconnect.

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