Shutterfly, Inc. Q2 2008 Earnings Call Transcript

Shutterfly, Inc. (SFLY)

Q2 2008 Earnings Call

July 30, 2008 5:00 pm ET

Executives

Marilyn Lattin - Director of Investor Relations

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

Mark J. Rubash - Chief Financial Officer

Analysts

Imran Khan - JP Morgan Securities, Inc.

Troy Mastin - William Blair & Company

Youssef H. Squali - Jeffries & Company, Inc.

Kristine Koerber - JMP Securities LLC

Alan Gould - Natixis Bleichroeder, Inc.

Domenic LaCava - Canaccord Adams

Presentation

Operator

Welcome to Shutterfly’s second quarter 2008 earnings conference call. (Operator Instructions) I would now like to turn the call over to Marilyn Lattin, Director of Investor Relations for Shutterfly.

Marilyn Lattin

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 our business. For more information regarding the 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 sin general, we refer you to the section entitled Risk Factors in the company’s latest quarterly report on Form 10Q 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 from calculations of measures made by other companies. A quantitative reconciliation of these non-GAAP financial measures to the most directly comparable GAAP financial measures has been included in this presentation and are available in our 2Q 2008 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.

Jeffrey T. Housenbold

Our agenda will start with the review of key highlights for the second quarter. Then I’ll turn the call over to Mark to review our financial performance in detail and provide guidance for Q3 2008 and full-year 2008. Then I’ll summarize and we’ll open up the call for Q&A. So let’s get started.

As you listen today to our remarks I’d like you to keep in mind three key messages. First, despite an increasingly tough macroeconomic environment we delivered our 30^th consecutive quarter of year-over-year revenue growth during Q2 2008 with better-than-expected gross and net margins. While we’re not satisfied with our top line growth, we are confident that our compelling suite of products and services and our continued innovation positions us well to continue leading in these early and large markets.

Second, we are focused on improving free cash flow in a sustained and long-term manner. During the first half of 2008 and especially during Q2 we are beginning to realize leverage in our business model. This leverage along with our disciplined expense management demonstrates that we can achieve sustained margin improvement even in the competitive market place.

Third, we continue to build for the future. We’re strengthening our brand and franchise and innovating with new products and services to delight our customers and increase their loyalty and evangelism of Shutterfly. We are also incubating both the sponsorship and advertising and commercial printing business. If successful, both initiatives have the potential to deliver new revenue streams, higher margins and increased free cash flow.

With those key messages in mind, I’ll provide a quick recap of key activities during the quarter. It was a very busy quarter from an innovation standpoint. We released three new major service and technology innovations, the largest ever in the company’s history. We had strong uptake in our new product introductions including designer cards and themed content for Mother’s and Father’s Days and in our core verticals, wedding, baby and travel. We saw healthy customer buying behavior during the two major holidays, Mother’s and Father’s Days, and we kicked off what is shaping up to be a successful summer marketing campaign centered on summer-time travel.

Now I’ll provide some more detail on each of these activities. In the last six months new technology releases have included Project Lightbox, Shutterfly Gallery, Share 2.0, and re-architecting and implementing a new storage platform. Each of these projects was larger than any single project in 2007. Consequently we planned an aggressive launch schedule in the first half of 2008 to give ourselves some operational runway before the Q4 holiday. Not surprisingly releasing these new services simultaneously caused some initial challenges that given the complexity of these releases impacted site performance, our key metrics and revenues especially around Father’s Day. However we quickly resolved those challenges and they are now behind us and customers are now embracing these innovations. I’ll provide a quick description of each.

Project Lightbox includes a series of expanded user experience improvements related to viewing and organizing photos while on our website. Its purpose is to help consumers better manage their content, improve the creation process and increase the velocity of non-print transactions.

We want to be the premier destination for sharing life’s joy for our targeted demographic of users who value ease of use, quality, security and the ability to create physical products. Therefore, in addition to our current service that allows for sharing with individuals we have added the ability to share with the community and with groups using our new Shutterfly Gallery and Share 2.0 offerings. We believe these new industry-leading enhancements will extend our customers’ already viral behavior while also strengthening their loyalty to Shutterfly.

Last quarter we discussed the introduction of Shutterfly Gallery where our customers can post their photo books online and view and comment about them. I’m pleased to say that viral behavior and customer inspiration continue to increase. Tens of thousands of photo books have been posted and the Make One Like This feature is inspiring customers while also helping them to accelerate their photo book creation process.

Shutterfly Share 2.0 is our most recent innovation. It enables customers to create their own personal password-protected social networking site for friends, family, groups and clubs. We launched the beta version of Share 2.0 during the second quarter and will launch a full version during Q3. Based upon extensive customer input, Share 2.0 combines the power and the benefits of photo sharing, logging, self publishing and social networking sites with a sophisticated security layer into one easy-to-use experience. We are very pleased with the early adoption. Within the first 12 weeks alone more than 40,000 Share 2.0 websites have been created and the feedback from customers has been fantastic. The youth case is broad based and truly inspiring. Our customers have created share sites for youth sports, charity events, family reunions, birthday parties, vacations, weddings, special interest groups like Harley-Davidson and Mercedes Benz car collectors, moms clubs, schools and classrooms, funerals and celebrations of life, church groups, and even small businesses.

In addition to Lightbox, Gallery and Share 2.0 which are all customer facing innovations, we have also completely redesigned the way we handle, display and store our customers’ content. This was necessary to provide both the Lightbox and Share 2.0 functionality and provides improved organization and sharing capabilities for our customers. From a technical standpoint it provides us both storage and media independence with greater scalability, performance and reliability.

Moving on to new products. In previous discussions I’ve described how we’re adopting more of a solutions approach to all of our merchandising. This means instead of simply launching new products we’re introducing products through merchandising and marketing initiatives that focus on customers’ key life events, interest and hobbies. So for example, this year we expanded our card selection to include designer cards but we’re merchandising them to specific use occasions such as baby and graduation. Receptivity for the designer cards has been high, more evidence that when our customers are presented with differentiated unique high quality products they embrace our line extensions and innovations.

Other new products introduced in Q2 included themed photo books, cards and other photo-based merchandise for both Mother’s and Father’s Days. As we mentioned during last quarter’s call, in 2008 a slower economy has meant that we continue to see strong customer traffic and purchases during key holidays with less activity during the in-between times. Both Mother’s Day and Father’s Day were good holidays for us in the second quarter. Customers responded well to our themed products.

On the vertical solutions front we have strong momentum with digital scrapbookers, a growing segment in a very viral enthusiastic $3 billion market. We recently introduced our fourth designer scrapbook with our partner CK Media along with dozens of new scrapbook pages from leading designer and scrapper Lisa Bernson.

Last month we kicked off our summer marketing campaign Hit the Road with a vacation travel theme, a key vertical focus area for Shutterfly. If you visit our website, you’ll see that we’re encouraging customers to post pictures of their vacations in progress on an interactive map of the US and enter into a sweepstakes contest. While summertime is traditionally a slow time for ecommerce, we are working hard to stay top of line with our customers while they’re creating important memories of summer vacations.

So that summarizes our key accomplishments for the quarter. Now I’d like to make a few comments about our overall business, the current economic outlook and our plans for increasing free cash flow.

On last quarter’s call we discussed how a top macroeconomic environment was affecting our business. In the second quarter the economy and consumer confidence have only worsened and it’s affected the financial results from some other premier retailers. In addition since they have few other levers to maneuver, the competition has chosen to continue to discount 4x6 prints. While we certainly can’t control either of these factors, it’s important that investors understand our strategy for 2008 in light of these issues.

As we mentioned last quarter we are focused on strengthening and extending our franchise and increasing our market leadership during this tough time. We are making smart well-considered decisions that balance both the short- and long-term objectives. That means we are investing in products and services, in people, in processes and in the systems that will drive our long-term success and growth in this market. It means staying close to our customers so that we introduce new products and services that delight them. It means providing outstanding service and support so that we increase customer loyalty and retention.

In fact Shutterfly was recently named number five in customer satisfaction by Foresee Results, a research firm that tracks customer satisfaction with Internet retailers. And we’re in excellent company. The top slots included Netflix, QVC and Amazon.

Extending the Shutterfly franchise also means staying laser focused on achieving leverage in our model and on managing our expenses and investments while adjusting to the realities of the current market, all while improving our free cash flow. We are focused on improving free cash flow through a number of targeted initiatives. Let me talk to some examples.

First, we’re outsourcing some manufacturing capacity for the fourth quarter peak volume to a select number of strategic partners who have the scale, quality and reliability to meet our customers’ tough standards. Second, we’re reducing storage costs by optimizing our technology architecture, integrating new vendors and negotiating down hardware costs. We’re also optimizing our promotional and discount strategy through further enhancements to our customer relationships management, targeting and segmentation capabilities. And lastly, we’re incubating new businesses such as commercial printing to utilize our expertise and available manufacturing capacity, and by adding on a limited and targeted basis sponsorships and contextual advertising to further monetize our large installed base of photo sharing traffic.

Let me provide a bit more detail on some leverage from the efficiencies that we’re achieving in our manufacturing strategy. And in a moment Mark will provide you with specifics on our 2008 cap ex guidance which we’ve consistently lowered since the beginning of the year. That’s because we believe we can derive greater leverage in manufacturing in two important ways.

First, our experience in Charlotte has demonstrated the benefits of operating in a business friendly region with a large labor pool. Consequently we have decided to close our facility in Hayward, California and are adding a manufacturing facility in Phoenix, Arizona. While Hayward will remain in full operating during the fourth quarter holidays, we believe this transition will yield further manufacturing efficiencies.

Second, in Q4 2007 we began selective testing of outsourcing production to several large manufacturing partners. Those initial tests went very well. Our partners were able to deliver on both the high quality and high service levels that we require. Consequently we intend to expand those outsourcing efforts for the Q4 2008 holidays across many but not all of our product lines.

We believe these two initiatives will enable us to reduce capital expenditures as a percentage of 2008 revenues.

With regard to expense management as both Q1 and Q2 2008 results show, we are demonstrating strong fiscal and operational discipline and we are subjecting every aspect of the business to intense cost management scrutiny.

So with that I’ll turn the call over to Mark to review our financials in detail.

Mark J. Rubash

I’ll begin my comments today with some observations about our performance in light of the current economic environment followed by a review of our key metrics and then a walk-through of this quarter’s operating results. I’ll conclude my comments with an overview of our Q308 and full-year 2008 financial guidance. Following that discussion I’ll turn the call back to Jeff for some closing comments and then we’ll open up for Q&A.

As I’ve mentioned in each of my last two conference calls, we continue to execute against a very difficult economic environment that is putting enormous strain on consumer discretionary spending. The rapid erosion of the consumer nest egg combined with the rise in unemployment, food prices and the price of gasoline have not only dampened consumer spending but has also greatly reduced consumer confidence. I continue to emphasize the economic headwinds to ensure that our business performance is evaluated in a relevant context.

To successfully navigate through this environment, we have been working hard these past two quarters to ensure that every dollar goes to its highest and best use. And as evidenced by our improved profitability this quarter, these efforts are beginning to yield sustainable operating leverage.

We’re improving our manufacturing cost structure by relocating to favorable operating locations, increasing our use of Q4 outsourcing, implementing more efficient production techniques, and leveraging our scale across all of our materials and shipping vendors. On the technology side we’ve improved our platform architecture, integrated new storage solutions and organized for rapid innovation and development cycles. In sales and marketing we’re optimizing our discount and promotion strategy, developing advanced analytic systems and increasing the precision of our targeted marketing efforts. And finally, in G&A we implemented the first phase of our new ERP system, advanced our intellectual property licensing program and have significantly reduced the cost of our audit and Sarbanes-Oxley compliance efforts.

So in summary, while we don’t know how long these tough economic times will last, we are confident in our strategy and we will continue to build on our long track record of industry-leading innovation, quality and execution.

So let’s now turn to key metrics. During Q2 we had 834,000 transacting customers who generated 1.6 million orders with an average order value of $22.70. This activity translates into year-over-year growth in customers’ orders and AOV of 14%, 7% and 11% respectively. While these overall metrics are healthy especially given the tough economic and competitive environment, we’re not satisfied with these growth rates and believe there is room for improvement as we sharpen our execution in preparation for the historically strong fourth quarter.

Last quarter on a one-time basis we shared a number of user engagement metrics to provide additional insight into user activity and seasonality patterns within the quarter. While we’re not disclosing these metrics this quarter, I will provide some observations on each starting with site visits. Site visits during Q2 continued to show solid year-over-year growth and a slight acceleration over the Q207 growth rate. New user registrations and image shares during the quarter were roughly flat with the prior year. In both cases we believe the moderated growth rates were largely attributable to the influx of new users from the Yahoo Photo customer migration which began in Q2 of last year as well as to the site performance issues Jeff mentioned earlier. And finally, the number of unique uploaders during Q2 continued to show solid double-digit year-over-year growth.

Consistent with our observations expressed during our prior conference calls we continue to see very healthy engagement and ordering activity around the traditional holidays with more dampened activity in between. This quarter during the periods leading up to Mother’s Day and Father’s Day we saw very strong engagement metrics and a clear lift in both order volumes and net revenues. Based on these recurring activity patterns, we continue to believe that we will see more moderated growth during Q3 and increased seasonality in the holiday rich fourth quarter.

Let’s now move through a discussion of our reported results starting with net revenues. Net revenues for the quarter totaled $35.4 million reflecting 19% year-over-year growth. The allocation of net revenues between new and existing customers was very consistent with the prior year at 21% and 79% respectively.

In terms of product mix net revenues from prints and personalized products and services represented 45% and 55% respectively. Also, net revenues from 4x6 prints represented 28% of total net revenues, down slightly from 32% in the prior year. In terms of net revenue growth rates prints increased 11% year-over-year and personalized products and services increased 26% year-over-year led by continued strong growth in our award-winning line of photo books. As I already mentioned, competition in 4x6 prints continues to be intense with some competitors even running promotions at prices well below their variable costs. Recently we have been testing a 15-cent promotion and have seen some positive price elasticity. As a result we plan to continue this test and other pricing promotion and bundled product offers during the second half of this year.

Our vertically integrated fully dedicated manufacturing resources not only give us the most efficient cost structure in the industry, they also provide much greater flexibility to deliver unique compelling and profitable offers to our customers.

Moving to cost of net revenues and gross margin, we reported a gross profit margin of 51% during Q2 which is consistent with the prior year and impressive given the fact that we now have two production facilities in operation. This strong margin performance resulted from several factors including increased utilization of our Charlotte plant, improvement in product mix, lower promotional discounts and improvements in both materials and shipping costs.

Technology and development costs totaled $9.8 million and include year-over-year increases of $1.5 million for depreciation, amortization and stock-based compensation. Excluding these amounts our technology and development spending increased $1.6 million or 37% from the prior year and reflects the incremental investments we’re making in the depth and quality of our products and services offerings.

As Jeff mentioned earlier, in the first half of 2008 we delivered four major service improvements that we believe would help increase viral customer acquisition and drive greater customer engagement and loyalty.

Continuing down the income statement, sales and marketing costs totaled $8.6 million in the quarter representing 24% of net revenues and in line with the 24% of net revenues reported in Q207. Our customer acquisition cost in Q208 was essentially flat with the prior year and consistent with our expectation.

General and administrative expenses for the quarter totaled $7.6 million or 21% of net revenues. As I mentioned earlier, we’re progressing on plan with our ERP implementation and other infrastructure systems and are beginning to see sustainable efficiencies in many of our highest cost areas particularly in the cost of our audit and Sarbanes-Oxley compliance efforts.

Continuing the discussion, adjusted EBITDA for the quarter was a positive $415,000 far better than our guidance which estimated a loss ranging from $2.4 million to $4.3 million. This EBITDA improvement resulted from a consistent sustained effort across the entire business to manage our cost structure in line with our revenue growth and is strong proof that we are beginning to realize the leverage opportunity inherent in our business model.

The effective tax rate for the quarter was 45% slightly improved from our guidance as a result of improved profitability, identification of additional qualifying R&D credits, and a reduction in ISO related permanent tax differences. As a reminder, please note that our cash tax rate continues to be extremely low due to the availability of NOL benefits and that our GAAP tax rate is very sensitive to changes either in pre-tax income or permanent differences such as R&D tax credits.

On a GAAP basis our net loss for the quarter totaled $4 million or $0.16 per share. On a non-GAAP basis, which excludes stock-based compensation and purchase accounting amortization, the net loss totaled $2.9 million or $0.12 per share. Shares used to compute EPS for the quarter totaled 25 million.

Now I’d like to provide some additional insight on our capital expenditures and on our cash investment and liquidity status. Capital expenditures during the quarter totaled $5.3 million which included $3.5 million for technology related equipment and software; $400,000 for print, manufacturing and office equipment; and $1.4 million in capitalized software development costs.

Cash and liquid investments at June 30 totaled $40.6 million. In addition we continued to carry investments in student loan backed auction rate securities which had a fair value at quarter end of $48.8 million. This revised valuation for the auction rate securities reflects an additional impairment totaling $960,000 which is reflected net of tax on the balance sheet as a component of other comprehensive income. While there is no current visibility to the resolution of this liquidity matter, all of our auction rate securities continue to be AAA rated and we continue to receive interest payments on schedule.

Regarding our cash resources, we are confident that the $40.6 million in available liquid cash and 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 resources with a $20 million 364-day revolving line of credit.

To complete my discussion today, I would now like to summarize our outlook for Q3 and the full year 2008 together with some additional insight on our underlying assumptions. Based primarily on our observations from Q1 and Q2 and the first few weeks of Q3, we expect to see continued year-over-year growth in core user engagements metrics but slower growth in terms of orders and net revenue. We have also remarked that customer buying activity has been strongest around traditional holidays and lower during non-holiday periods. Accordingly please keep in mind that Q3 contains no key gift-giving holidays. 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 manufacturing, we believe that we currently have sufficient plant capacity to meet customer demand for the balance of 2008. In previous calls and as Jeff mentioned today, we have discussed the favorable operating environment in the Charlotte area and the efficiencies that are being realized by our manufacturing operations there. To extend these efficiencies to our entire manufacturing footprint we have decided to close our Hayward facility early next year and begin production in a new facility in Phoenix, Arizona by April 1, 2009.

Our financial guidance for Q3 and the full year 2008 includes all costs associated with terminating our Hayward leases, providing severance and relocation packages to effective employees, as well as the costs to accelerate amortization of Hayward leasehold improvements through the final occupancy date. During Q308 and Q4 these largely one-time costs are expected to total about $380,000 and $500,000 respectively and are reflected in our gross profit margin guidance.

With these comments as context, I’ll now turn to our guidance for Q3 and the full year 2008. Starting with Q3, we expect net revenues to range from $33 million to $36 million which reflects year-over-year growth of up to 10%. 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 a loss of $14 million to $16 million resulting in GAAP operating loss margins between approximately -39% and -48%. We expect our non-GAAP operating loss to range from a loss of $11 million to a loss of $13 million resulting in non-GAAP operating loss margins between approximately -31% and -39%.

We expect our adjusted EBITDA will range between a loss of $4 million and a loss of $6 million. Also note that while we have not decided to permanently extend our promotional 15-cent pricing for 4x6 prints, our guidance including all anticipated margins assume this price point.

We expect our GAAP effective tax rate to range between 45% and 76% 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 $0.15 to a loss of $0.30 and a non-GAAP loss per share to range from a loss of $0.25 to a loss of $0.30. 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 $240 million reflecting year-over-year increases ranging from 20% to 29%. As you will note, this revised guidance reflects a $5 million reduction to the top end of the guidance range due largely to the continuing weak economy. However we continue to be confident about sustaining and possibly improving our overall profitability levels. We expect the full-year GAAP gross profit margin to range from 53% to 55% of net revenues and our non-GAAP gross profit margin to range from 54% to 56% of net revenues. This revised guidance reflects a 100 basis point improvement in our full-year gross profit margin and fully incorporates the costs for severance and relocation and accelerated leasehold amortization associated with the closing of our Hayward plant.

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 ranging from 4% to 8%. We expect that 2008 full-year EBITDA margins will range from 16% to 18% of net revenues.

The full-year GAAP effective tax rate is now expected to range from 45% to 76% a slight improvement from our prior guidance of 49% to 78%. The 2008 full-year non-GAAP effective tax rate is expected to range from 38% to 39%.

For purposes of calculating full-year 2008 GAAP and non-GAAP diluted EPS, we estimate that the weighted average common and potential common shares outstanding will approximate 27.2 million. We expect the full-year 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 approximate 15% of net revenues, down from the 16.5% in our prior guidance and a substantial improvement over the prior year. Our ability to reduce capital expenditures as a percent of net revenues is based on several factors.

First as Jeff mentioned, in Q4 of last year we began selective testing a small number of outsourced manufacturing partners. The results of that program were very positive with respect to both cost and quality, and as a result we intend to expand our outsourcing program this holiday season to reduce our peak capacity requirements.

In addition, we continue to explore ways to leverage our available capacity during non-peak production periods. This quarter we completed a few small commercial print jobs as a test of our ability to perform for commercial customers. While small in size, the test did provide some early validation of our ability to serve this market and we will continue to actively seek additional commercial printing opportunities in future periods.

So in summary, I would like to highlight that while we have reduced the top end of our full-year revenue guidance, our attention to cost management and leverage opportunities has enabled us to increase our gross margin and maintain our existing operating margin and earnings per share guidance. In addition, with the continued reductions in our capital spending requirements we expect to deliver meaningful and sustainable improvements to 2008 free cash flow.

Before I return the call back to Jeff, I’d like to remind you that our insights into financial performance will develop through the remainder of the year. As a result we will revisit our financial guidance on our Q3 2008 earnings call.

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. Back to you Jeff.

Jeffrey T. Housenbold

Now I’ll close by reiterating the five pillars of our investment thesis.

First, the markets for social expression and personal publishing are enormous, evolving and in the early days of significant transformation. Thus it’s our job to ensure that consumers embrace and choose Shutterfly as the premier 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 will drive sustainable advantages including growing awareness and trial belt service which spurs increasing customer loyalty which then drives passionate evangelicism of future awareness and trial of Shutterfly. We believe this virtuous cycle ultimately results in increasing revenues, high ASPs and more efficient customer acquisition costs.

Third, Shutterfly is relentlessly focused on delighting our customers which is why repeat business from existing customers is consistently in the 75% range of total revenues.

Fourth, we control our own manufacturing which allows us to innovate rapidly with differentiated unique high quality products while driving continuous efficiencies and improved margins.

And lastly, we have an experienced leadership team that has consistently demonstrated operational and financial discipline in executing our business model.

So that summarizes our prepared remarks. At this point we’ll open up the call to your questions.

Question-and-Answer Session

Operator

(Operator Instructions) Our first question comes from Imran Khan - JP Morgan Securities, Inc.

Imran Khan - JP Morgan Securities, Inc.

First, if I look at your Q3 guidance on the midpoint, you’re guiding six percentage point growth and the fourth quarter you’re guiding midpoint roughly 30% percentage point growth. I know you talked about how there’s no holiday in the third quarter so I’m trying to understand if you can increase our comfort levels, what kind of growth rate you are seeing during the holiday season on a year-over-year basis to feel comfort level that you can grow your business 30% on a year-over-year basis in the fourth quarter?

Mark J. Rubash

What we saw this quarter, and I’ll use rough numbers because there’s no precise way to actually know exactly what was attributed to a holiday, but in those periods around Mother’s Day and Father’s Day we saw anywhere from a 6% and 7% to a 12% lift in revenues versus other parts of the quarter. So it was clear and insignificant during those peak holiday periods.

Imran Khan - JP Morgan Securities, Inc.

Secondly, it seems like your average order value increased despite a weaker macroeconomic environment to me and it’s counter intuitive. So can you help us to understand what’s driving such a healthy growth in AOV?

Jeffrey T. Housenbold

I think primarily what we saw was the continuing mix shift from prints to personalized products and services that have an inherent higher average order value. We also last year at this time had kicked off our summer memories campaign where we were giving away five million 4x6 prints associated with various activities on the website and as customers were redeeming that the average order value was lower because part of their basket was free prints. So as you saw personalized products and services go from 52% of revenue last year to 55% that was driving the average order value.

Operator

Our next question comes from Troy Mastin - William Blair & Company.

Troy Mastin - William Blair & Company

What kind of impact do you think you’ll see in 2009 as a result of the move away from Hayward into the new facility in Phoenix?

Mark J. Rubash

Basically the big difference, just like Charlotte is the labor costs in the Phoenix area. That’s where the lion’s share of savings will come from and the labor costs in Phoenix are about the same as Charlotte and that’s about a 30% to 35% reduction from Hayward levels. So it will depend on obviously the mix of products and to what extent we’re moving from low labor content products to higher labor content but that’s where we’ll see the most significant savings. After that there’s also savings on the cost of the facility itself and power and shipping should be pretty consistent with the Bay area since it’s a West Coast location.

Troy Mastin - William Blair & Company

Can you provide an estimate for us what percentage of total revenue or costs today comes from Hayward-related headcount?

Mark J. Rubash

We haven’t broken that out historically so I don’t think I’m going to try and do it in my head right now.

Jeffrey T. Housenbold

If you look at the costs associated with winding down Hayward, it’s about $900,000 and opening the new plant the break-even point will be about 12 to 18 months.

Mark J. Rubash

I will add, and I’ve said this before publicly, in Q4 last year we hired approximately a little over 1,000 temporary workers for Q4 period. So even if you just use that and looked at the intensity of Q4, if you get a split of that from Hayward to Phoenix at a 30% to 35% lower labor cost, it’s a measurable savings. And then do your calculations throughout the year.

Troy Mastin - William Blair & Company

And you had mentioned that some of your site usability issues adversely affected your revenue on Father’s Day. Have you or can you provide an estimate for us in terms of the adverse effect?

Mark J. Rubash

We don’t have a quantification that we’re going to provide. I will say that it was something that was definitely noticeable. There were periods of time where the site was really barely functional. Some of that was in the Father’s Day period. So we definitely lost some ground on user metrics and we lost some ground on revenue. But that’s part of the business and they’re behind us right now. The site’s performing very well.

Troy Mastin - William Blair & Company

Regarding your assumption in your guidance, if I heard you correctly, that you will be pricing 4x6 prints at 15-cents for the remainder of the year; even though you haven’t made that decision, I assume I could take 15-cents versus 19-cents last year to get a rough estimate of how much of an adverse affect that is having on your revenue for the back half of 2008 versus 2007 or would the promotional mix in some way influence your average price for 4x6 in 08 versus 07 beyond just that sort of rate card pricing?

Jeffrey T. Housenbold

There are a couple things working at once here Troy. One is the various promotions we do, so the 19-cent rate card on our average 4x6 is actually lower than that because of our prepaid print plans. And secondly, I think as you think about we’re continually testing various price points and bundling and promotion, the key to it all is finding that [non-purado] efficient point in the elasticity curve that balances both the revenue and the profitability. So we’ll lower print prices to a point where we’re at beneficial or neutral on both of those aspects. So you have to take into account the elasticity as well. So you might see lower revenue per unit but higher volume will offset that.

Troy Mastin - William Blair & Company

And when you do that analysis you’re doing it based on current period metrics, not lifetime value metrics or have you considered both of those?

Jeffrey T. Housenbold

It’s primarily current period because we know that as we get a customer in and as he or she moves through their lifecycle, we’re able to further monetize them. So the balance on the 4x6 print which was 22% of revenue last year and continues to decline is less of an impactful lever over the lifetime of the customer.

Troy Mastin - William Blair & Company

Final question. I’m still trying to understand the third quarter guidance and the implied acceleration in the fourth quarter. At the midpoint I think you’re at about 5% growth in the third quarter. To me that seems pretty straight forward that your non-holiday periods are growing at that sort of a rate, which would imply your holiday periods might be growing much closer to 30%. Is that kind of roughly what you’ve been seeing?

Mark J. Rubash

I think one of the things that we said at the beginning of the year is we really expected the seasonal intensity to increase this year and I think it was in the January or the April call we talked about modeling off of 2006 types of seasonality patterns. We do expect t hat will be the case this year where Q3 you have one, it’s not a holiday rich period and two, there’s a lot of distractions both the economy and the elections, the Olympics and so on. It’s going to be a tough quarter we think for us and others in the discretionary consumer space. Having said, that though we’re continuing to add new customers. They’re continuing to engage in uploading and sharing and we have a lot of new products and features out, and when we do get to Q4 we’re hopeful and somewhat optimistic that holiday rich period is going to prove very well for us.

Jeffrey T. Housenbold

In addition, starting in late Q2 last year flowing into Q3 and the early part of Q4 we had the migration of Sony and Yahoo in the base from last year. And that’s why I think we’re trying to get you guys to look at 2006 as a cleaner proxy than 2007 for the seasonality.

Troy Mastin - William Blair & Company

Sony and Yahoo would have helped Q3 relative to Q2 I would assume?

Jeffrey T. Housenbold

In last year, yes.

Operator

Our next question comes from Youssef H. Squali - Jefferies & Company, Inc.

Youssef H. Squali - Jefferies & Company, Inc.

Mark, if I look at the biggest delta between what you report and what people were expecting, what we were expecting, it really came in large part on the gross margin side where we outperformed. But if I look at your guidance for Q3, I guess on the top line the delta is only about $1 million or $1.5 million at the midpoint but if I look at gross margin, you’re guiding for again substantial decline both sequentially and year-on-year. Could you shed more light on why that should happen and that obviously again feeding into the Q4 question assumes a huge kind of hockey stick? And then I have another question for Jeff but I’ll wait.

Mark J. Rubash

I think the first thing to keep in mind is we are getting leverage both on materials and shipping and on our production efficiency in overall manufacturing, and that’s what’s giving us the confidence to lift the full-year gross margins by a point. As we look into Q3 and looking sequentially, we expect that our materials, labor, shipping costs are going to be largely flat as a percentage but we have a couple of things going on. Part of that is preparing for Q4 so in Q3 we typically ramp up our customer support and training not only for CS but the print manufacturing team on the floor. So we’re bringing in people and we’re doing training. We’re also planning to do a reconfiguration of equipment in Charlotte this quarter which will give us further efficiency in the long term. And finally, we’re absorbing all of the costs or at least the prorated costs of the Hayward severance and accelerated amortization. So I would look sequentially as part a buildup in preparation for Q4 and part optimization of the plant floor in Charlotte and then lastly absorbing the cost of the plan to close down the Hayward facility. But full year we expect to be up a point versus our last guidance.

Youssef H. Squali - Jefferies & Company, Inc.

For Jeff, to the issue of outsourcing versus continuing to do things in-house, philosophically how should we be thinking about that? I mean, historically you’ve talked about the competitive advantage you have in owning the machinery and how owning the machinery provided you with the most efficient cost structure. Where are you going with that? How much of your production do you expect this year to be done outside of your walls and going forward? How should we be thinking about that versus in-house?

Jeffrey T. Housenbold

I think we have a number of moving parts that we were announcing this quarter as it relates to our supply chain strategy and we’re pretty excited about them, so let me try to tackle those holistically and answer your question within that answer. First, if you think about the seasonality of our business, largely what we’ve done is purchase equipment for our peak period which occurs for about a two-week timeframe in the fourth quarter. So while we talk about the fourth quarter broadly, it’s really those two weeks leading up to the last week before Christmas.

What we did last year was outsource that peak overflow to a handful of very strategic partners who have the capacity, the quality and the customer service capabilities to meet both our requirements and those of our customers. And that went very well. Now we didn’t do that across all of our product lines or SKUs, but we did that in select areas in cases where we thought that the partners were best equipped to do. Based upon that experience last year, we’re expanding that program this year in terms of numbers, strategic partners and the amount of volume as this fourth quarter will be larger than last fourth quarter. So that impacts us financially in a very positive way in that we don’t have to spend extra cap ex on those machines just for that small period during the year and then we would have that available capacity for the remainder of the year.

So we’re still very committed to owning our manufacturing and accruing the strategic advantages of quality innovation time to market and customer service, and we’re doing that in our Charlotte plant, we’ll continue to do that in Hayward until it winds down in early 2009, and then as Phoenix comes on.

The second area is the investment in Phoenix. Based upon the experience in Charlotte in both the efficiencies we gained because of a brand new layout in one building in the productivity, the reduced waste and then also the efficiency gains we got from labor, real estate, shipping and power, that led us to the decision that having a single West Coast plant in a lower labor area as we move more and more to higher labor content products like photo books was the right strategic decision.

And the third key initiative if you look at the intervening periods from Q1 through Q3 and the first two months of Q4, we have available capacity and we have deep talent and expertise in front end web interfaces and just in time variable print on demand capability. So we’re in the early stages and we ran some test runs with a handful of commercial print clients this quarter, and those tests went well. So we know that we can provide the quality, the turnaround and the cost to make us competitive in that commercial print market. And any dollars we get there are going to largely flow through the P&L because we already have the machines, we have the labor and we have the depreciation of the fixed assets. So while it may be lower gross margin, it will have higher free cash flow for us. And since we can price aggressively because of that flow-through relative to commercial printers who make only a 6% to 12% margin, we think our expertise and the power of our profitability model will allow us to be very aggressive in the market, and as we continue to incubate and grow this has the potential for deep impact on the free cash flow line.

Youssef H. Squali - Jefferies & Company, Inc.

So just a quick follow up on that. How do you sell to the commercial print market? Do you hire in direct sales people?

Jeffrey T. Housenbold

I think there are number of ways we can go about this. First is there are a number of brokers out there in the market place that are already aggregating demand and they’re looking for places to go. So that’s one. Second is the partners that we have through our network of equipment vendors and relationships in the industry, they’re always looking for places that have high amounts of capacity in digital print on demand. In fact we have the largest footprint in the world. So as more and more commercial print’s moving to digital, our available capacity becomes a very attractive vehicle. And those vendors remember make their money on the consumables of ink and paper, so the more impressions they can drive across those, they’re going to make money. So they’re incented to send us business. So that’s where we’re going to go in early days. We’re not going to go hire a large sales force here. Though we may hire one or two people to go out and drum up business, we think the ability to partner will be very effective in the early days.

Youssef H. Squali - Jefferies & Company, Inc.

One last question, going back to the outsourced versus in-house. Can you just speak to the margin characteristic or the marginal differential between outsourced versus in-house?

Jeffrey T. Housenbold

It’s relatively small. So certainly we’re providing a little bit of margin to our outsourced partners but remember they have the same opportunity that we do. They have excess capacity because they have counter seasonality, so they could get aggressive on pricing. So while it may have a minor impact on gross margin, you’ve seen we’ve taken up overall gross margins by 100 basis points. So limited impact. Really where we feel the benefit is in the reduced cap ex as we’re now at 15% of revenue where I believe we started the year 17.5% to 18.5% and last year around 18.5%. So I think the efforts of the outsourcing and then just continued optimization of our storage technology and sharpening our pencil across every area of the business is allowing us to drive increased efficiency, lower cap ex and ultimately higher free cash flow.

Operator

Our next question comes from Kristine Koerber - JMP Securities LLC.

Kristine Koerber - JMP Securities LLC

First of all with regards to the 4x6 print business and testing the 15-cent prints, if you’re making money why not permanently move to 15-cents just to be more competitive?

Jeffrey T. Housenbold

We’re still in the process Kristine of testing the various price points and thinking about the interaction of the rate card against our prepaid print and our membership plans. So once we’re finalized with kind of this sensitivity analysis and testing in the market, then we’ll make a final decision. I think what we’re saying is we found the 15 cents to have a positive impact, we extended the length o that promotion, but we’re continually testing a number of other initiatives and then we’ll have more to update you guys on at the end of the third quarter.

Kristine Koerber - JMP Securities LLC

Second, can you update us on where you are as far as further monetizing your customer base, i.e. possibly charging for storage?

Jeffrey T. Housenbold

We always think about the three ways in which to monetize a user base. First and foremost is ecommerce which we have dimensionable success in doing. The second is in sponsorships and advertising, and in today’s Wall Street Journal article it was mentioned that on our new Share 2.0 sharing platform we’re going to start to monetize through selected contextually relevant sponsorship and advertising. So as we have tens and tens of millions of shares going out every year, we have the ability to monetize who are more users rather than customers and extend the monetization platform. The third way is in subscriptions. Today we have a small business in the membership plans but we think that as we roll out features like video and some premium features on Share that we have the opportunity to further monetize through subscriptions not dissimilar from how Google or Yahoo! Flickr or Smugmug or any of the other players are charging for premium, for no advertising and for video storage.

Operator

Our next question comes from Alan Gould - Natixis Bleichroeder, Inc.

Alan Gould - Natixis Bleichroeder, Inc.

What capacity is Charlotte currently operating at and do you expect it to be at 100% during the peak fourth quarter season?

Jeffrey T. Housenbold

We’re currently running Charlotte between 60% and 70% capacity. We believe we have plenty of capacity to run for this fourth quarter between Hayward and Charlotte. During those kinds of two to three week peak business weeks, we run both plants flat out at about 100%. So both Hayward and Charlotte will get us through this year and as we ramp up the new facility in Phoenix Q1 and Q2 of next year, that will come on and handle the capacity needs for 2009 and beyond.

Alan Gould - Natixis Bleichroeder, Inc.

And what capacity is Hayward at now?

Mark J. Rubash

Hayward we’re at a much lower capacity than Charlotte. We’re trying to divert as much of this off season traffic to Charlotte where the efficiency and labor costs are lower. So we have a fair amount of capacity in Hayward currently but through fourth quarter both of them will optimize based on order routing and the nature of the products.

Alan Gould - Natixis Bleichroeder, Inc.

How big an opportunity do you think the commercial printing business could be?

Mark J. Rubash

If you start the total addressable market, we’re talking about hundreds of billions of dollars. But as you get it down to the piece of business that is run today on digital presses that are variable content and just in time, that number is much smaller but growing quite rapidly as direct marketers are finding the advantage of customizing the marketing collateral and then also in CPG companies are looking at unique and customized packaging. So those are the two key areas: Marketing collateral and packaging. And that market is quite robust and you see significant investments by the Kodaks and the Xeroxes and the HPs of the world from the hardware, software and consumable side. So we think that it is a very large market and we think that our footprint provides and our capabilities provide some unique competitive advantages. I think we’re going into it slow, we’re making sure that we do it right, we’re making sure that we don’t disrupt meeting the needs of our consumers today but we think that the opportunity for commercial can be substantial in the out years and have a significant impact on free cash flow.

Jeffrey T. Housenbold

I think one thing to note about the market, particularly with the variable digital press, most of the capacity in the market is much smaller than our footprint. So any large targeted advertiser is having to find solutions that are very fragmented across a large number of partners. And one of the things we bring is tremendous available capacity where we can bring much better pricing and much better efficiency to the campaigns.

Alan Gould - Natixis Bleichroeder, Inc.

Can you give us a sense of your new active customers in the quarter versus last year?

Jeffrey T. Housenbold

We don’t typically disclose the specific number of new customers but one of the things we continue to see is that new customers are activating with a higher average order value than they traditionally have. Part of that is they’re becoming more aware of what you can do beyond the 4x6 print so their first order has a photo book or a card or a calendar or our new stationery line in it driving average order value up. So new customers historically have looked lower in terms of their first year revenue versus historical customers but that differential is diminishing rapidly as we continue to diversify towards the personalized products and services.

Alan Gould - Natixis Bleichroeder, Inc.

I know you don’t break out new versus old customers but could you just tell us if the new customers are up or down versus last year?

Jeffrey T. Housenbold

We haven’t disclosed the direction of new versus existing. I think the proxy that we use is the revenue coming from them so last year Q2 of 07 22% of revenue came from new and 78% from existing. That was 21% and 79% respectively this quarter. So pretty consistent with last year.

Operator

Our next question comes from Domenic LaCava - Canaccord Adams.

Domenic LaCava - Canaccord Adams

Can you talk a little bit about when you expect commercial printing initiatives to hit the model? I know you said the out years but is that something we can expect early 09?

Jeffrey T. Housenbold

We’re still in the incubation phase so I think we’ll continue to develop out capabilities, make sure we’re delivering on a solution for the industry throughout this year. I think there’s potential for it having impact on next year’s P&L. As we move through the year we’ll come back and give you guys an update. This type of work will be a little lumpier. It tends to be longer sales cycles but once we kind of hit a stride and the industry knows that we’re open for business, we think in the out years that we’ll be able to fill the pipeline much more efficiently.

Domenic LaCava - Canaccord Adams

You may have touched on this but did you discuss the impact of oil prices on your end costs in Q2 and then your expectations for the next few quarters?

Mark J. Rubash

We didn’t discuss it yet but I’ll give you some insight. One is we tend to split most of our shipping through both USPS and UPS. The UPS relationship is new and the contract there does have fuel surcharges and those costs we think were fairly well insulated for the near term and the expectations are incorporated in the guidance. In terms of this particular quarter we saw a very consistent relationship of shipping costs as a percent of revenue and shipping margins historically. So we haven’t really seen any fundamental change through Q2.

Domenic LaCava - Canaccord Adams

Any thoughts on international expansion?

Jeffrey T. Housenbold

It continues to be an opportunity that we are evaluating in the billed-by-partner or rent kind of philosophy as consumers across the globe want to share their stories in unique ways and they’re starting to become aware of things like photo books and personalized greeting cards and personalized calendars. We think the opportunity is large. But we don’t have anything to announce at the current time.

Domenic LaCava - Canaccord Adams

So it’s fair to say the gating item you’re now assessing the adoption of the merchandise piece of the business. Is that fair to say?

Jeffrey T. Housenbold

I think it’s both consumer awareness, adoption curves, it’s understanding the right approach in the right region. There are some regions where partnership is required particularly in Asia. There are other areas like Europe that you can do a green field. So I think it’s going through those evaluations. And then it’s also understanding the investment required and the period of time until you can harvest that investment, its impact on our P&L and our ability to make investments across other parts of our strategy and portfolio such as new feature functionality, commercial printing, sponsorships, and advertising. So it’s not just the analysis of the customer; it’s kind of weighing it in the totality of all the things that we want to do given that we have so many high positive ROI projects on our plate.

Operator

That does conclude our question and answer session.

Jeffrey T. Housenbold

I want to thank everyone for joining us on the Q2 call today. While we continue to face some macroeconomic headwinds, we think the investments we’re making in new products and services like Share 2.0, Lightbox, Public Gallery, the re-architecting of our media storage platform which will allow us to add additional types of content, our investments in further monetization in subscriptions and sponsorship and advertising, and then our initial forays here into the commercial print business keys us up well for very strong growth in the future as well as a continued discipline in both expense management and on reducing capital expenditures to drive increasing free cash flow. So we look forward to updating you again at the end of this quarter.

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