Shutterfly (SFLY) Q1 2018 Results - Earnings Call Transcript

Shutterfly, Inc. (NASDAQ:SFLY) Q1 2018 Earnings Call May 1, 2018 5:00 PM ET

Executives

Shawn Tabak - Shutterfly, Inc.

Christopher North - Shutterfly, Inc.

Michael W. Pope - Shutterfly, Inc.

Analysts

Naved Khan - SunTrust Robinson Humphrey, Inc.

Kerry Rice - Needham & Co. LLC

Victor Anthony - Aegis Capital Corp.

Christopher Merwin - Goldman Sachs & Co. LLC

Operator

Good afternoon, and welcome to the Shutterfly First Quarter 2018 Earnings Conference Call. Please note this event is being recorded. I would now like to turn the conference over to Shawn Tabak, Vice President of Investor Relations. Please go ahead.

Shawn Tabak - Shutterfly, Inc.

Thank you, operator. Good afternoon, everyone, and welcome to Shutterfly's first quarter 2018 earnings call. With us today are Christopher North, our Chief Executive Officer; and Mike Pope, our Chief Financial Officer.

By now, you should have received a copy of our earnings announcements, which crossed the Wire just after the market closed. If you need a copy of the press release, please go to shutterflyinc.com to find an electronic copy. Our presentation is also available on our Investor Relations site. The audio of this conference call is being recorded for playback purposes and a replay will be made available within a few hours.

Before we begin, I would like to note that our discussion today may 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 the assumptions underlying those statements 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 in general, please refer to the Risk Factors section of our most recent Form 10-K and our other filings with the SEC.

I would also like to note that any forward-looking statements made on this call reflect information and analyses as of today and we assume no obligation to update this information. This information may contain certain financial performance measures that are different from financial measures calculated in accordance with GAAP and may be different from calculations or measures made by other companies.

To the extent possible, a quantitative reconciliation of these non-GAAP financial measures to the most directly comparable GAAP financial measures is available on the Investor Relations section of our website at shutterflyinc.com.

Now, I would like to turn the call over to Chris. Chris?

Christopher North - Shutterfly, Inc.

Thanks, Shawn. I'd like to welcome everyone to Shutterfly's first quarter 2018 earnings call. Let me start by saying how excited we are about the path we've embarked on and what it means for our customers, shareholders and employees in 2018 and beyond. Last year's restructuring streamlined the company, allowing us to invest more in customer-facing innovation, while delivering greater profits for shareholders. The Shutterfly Consumer single platform migration we completed last year allows us to leverage that innovation across more brands and a larger customer base.

Shutterfly Business Solutions revenue has almost doubled in just two years since 2015, as we leverage our world-class manufacturing platform to help other businesses provide personalized communications to their customers. And of course, with the official closing of the Lifetouch acquisition on April 2, we dramatically increased our customer base, nearly doubled our revenue to more than $2 billion and set ourselves up to almost double our adjusted EBITDA by 2020. We've come a long way in the last two years, but we're even more excited about what's ahead.

Today, I'll start by sharing an update on our Q1 2018 Shutterfly business performance. I'll then provide an update on the Lifetouch acquisition. After that, Mike Pope will present financial results for the first quarter of 2018 and update our outlook for the year.

I'm pleased to say that we had a successful first quarter. Our Q1 results met or beat guidance on the most important metrics and showed a significant improvement in profitability over the first quarter of 2017. At the same time, we continue to make good progress against our key areas of strategic focus.

First quarter net revenues were $199.7 million, above the high end of guidance, led by organic Shutterfly brand growth, continued rapid mobile growth and over-delivery in SBS. Adjusted EBITDA for the first quarter was $7.1 million, slightly better than expected. That's a $9 million improvement in adjusted EBITDA versus Q1 2017, thanks to last year's platform consolidation and restructuring, as well as organic growth in the Shutterfly brand.

In the Shutterfly Consumer segment, the Shutterfly brand delivered organic growth of 10%, with solid performance across the business. We saw particularly good performance in Photo Books, as well as in the Shutterfly Wedding Shop, which launched in the third quarter of 2017. As expected, this healthy Shutterfly brand growth was offset by a loss of revenue from the three websites we shuttered in 2017: Tiny Prints, Wedding Paper Divas, and MyPublisher.

To help investors better understand the underlying growth in our Consumer business, we began providing additional brand level metrics the last fall and will continue doing so this year. As a reminder, we shuttered MyPublisher in the middle of the second quarter of 2017, the Tiny Prints website towards the end of the second quarter of 2017 and Wedding Paper Divas towards the end of the third quarter of 2017 and will only have a like-for-like comparison to the prior year beginning in Q4 2018.

In addition to organic Shutterfly growth, Shutterfly.com also benefits from revenue we retain from customers of the websites we shuttered last year. While we retained approximately 75% of revenue from these legacy websites in Q4 2017 versus Q4 2016, we expect to retain a significantly lower percentage of revenue in Q1 to Q3. The reason for this is that Q1 to Q3 are quarters in which the legacy websites historically relied on a much higher mix of newly acquired customers each year, whereas Q4 is primarily a period of repeat business given that Tiny Prints enjoys strong Q4 to Q4 loyalty each year.

For Q1, we retained approximately 30% of revenue from the shuttered websites compared to last year, roughly in line with our expectations. More broadly, across our Shutterfly Consumer business, we continue to execute against our strategic initiatives. A key part of our strategy includes greater targeting and personalization across the entire customer journey, including a more targeted approach to pricing and promotions. In particular, we're gradually reducing our reliance on our most aggressive promotions including free promotions.

While free promotions do have their place, particularly when they serve strategic goals such as customer acquisition to our mobile app, we're increasingly being more selective in how we target free promotions in order to continue to improve the quality of revenue, drive a higher mix of paid purchases and protect our premium brand position. In some cases, including in Q1, these actions have the near-term impact of reducing the overall number of orders and the active customer count, but was the right thing to do for the business.

The actions we took to refine our use of free promotions dampened personalized gifts and home décor growth in Q1, a category which historically has made significant use of free promotions for lower cost products such as magnets. We saw double-digit revenue growth in paid purchases in personalized gifts and home décor in the first quarter. In fact, Q1 saw our strongest paid growth in the category in more than two years. However, paid growth in the category was partially offset by a decline in free purchases resulting from the deliberate actions we took around free promotions, resulting in high single-digit overall revenue growth in the category in Q1.

Mobile continues to grow strongly with mobile purchases increasing almost 400 basis points year-over-year to 27% of Shutterfly brand revenue. We continue to expand the range of products available in the app, adding eight products in the first quarter. The broader range of products on mobile is helping drive higher mobile average order value, as customers of the app increasingly purchase personalized gifts and home décor, photo books and cards and stationery. In the first quarter, we had over 1 million app downloads and continue to see a high install to first order ratio and attractive customer acquisition costs.

We continue to expand the range of products we offer customers launching five new personalized gifts and home décor products including napkins, trivets, shot glasses, unscented candles and new puzzle sizes in Q1. We'll continue to add to the range throughout the year and are on track to launch the new kids and pets categories in the third quarter.

Turning to Shutterfly Business Solutions or SBS. Revenue was $47.7 million in the first quarter, 52% growth year-over-year. SBS growth was driven by the major multi-year deal we signed in Q3 2017 with an existing technology client where volumes ramped more rapidly than planned in the first quarter. As we've discussed previously, while the early phases of this deal are lower margin than we typically deliver in SBS, we're on track to improve margins in the second half of 2018.

Now, let's shift gears and talk about the Lifetouch acquisition. Our plans for bringing together Shutterfly and Lifetouch build on our common mission of sharing life story through photos. As undisputed leaders in our respected verticals, we'll build on the strong competitive advantages that each business has today, while leveraging our highly complementary assets to drive further scale and profitability.

Joint Lifetouch and Shutterfly working teams coordinated via dedicated integration management office are already focused on realizing the three key value creation opportunities that we previously articulated. First, gaining access to many Lifetouch customers as Shutterfly customers. Second, offering Shutterfly's broader product range to Lifetouch customers and accelerating the development of Lifetouch's online ordering platform. And third, realizing significant supply chain manufacturing and fulfillment synergies.

From a financial perspective, with this acquisition, we're targeting adjusted EBITDA of a minimum of $450 million in 2020, including $50 million from revenue and cost synergies. Going forward, we plan to operate three business segments, Shutterfly Consumer, Lifetouch and Shutterfly Business Solutions.

I'm pleased to say that Lifetouch's business has shown solid performance over the first nine months of their fiscal year, which ends on June 30, in line with Lifetouch management's expectations as well as ours. Lifetouch delivered solid performance in their schools and studios businesses, partially offset by continued weaker performance in their church business. Lifetouch's key selling season, the fall Picture Day tradition in schools was successful, achieving a modest increase in school accounts for the first time in the recent history.

I also want to provide an update on Lifetouch's iMemories business. Lifetouch purchased iMemories in 2016 to provide a cloud photo storage and organization service as well as a broader range of photo-based products to its customers. At the time we agreed to purchase Lifetouch, we anticipated that we would ultimately exit the iMemories business as over time we expect to offer the Shutterfly's photo service and our broader range of products to Lifetouch customers.

Since closing the Lifetouch acquisition, we've decided to accelerate the process of exiting iMemories and now expect to exit the business by the end of the second quarter. iMemories was previously expected to provide $22 million in revenue in 2018 and is roughly a breakeven business.

Before I hand it over to Mike, I'll simply say that we're pleased with continued progress we made in Q1 and, in particular, by the growth of the Shutterfly brand, strong mobile growth, overperformance in SBS and improving profitability of the business overall and we couldn't be more excited to come together with Lifetouch.

Now, Mike will share the details of our Q1 financial results and guidance.

Michael W. Pope - Shutterfly, Inc.

Thank you, Chris, and good afternoon, everyone. Net revenues for the first quarter totaled $199.7 million representing an increase of 4% over the prior year, coming in above the high end of our guidance range. In the quarter, Shutterfly Consumer revenue was a $152.1 million, consistent with our expectations of the mid-single-digit decline. Growth in the Shutterfly brand was offset by anticipated revenue declines in the non-Shutterfly brands due to the platform consolidation and the branch shutdowns over the course of the past year.

We've included a revenue bridge in the appendix of this presentation to help investors better understand the Shutterfly brand performance during the first quarter.

In the first quarter, net revenues from our SBS business grew 52% over the prior year to $47.7 million, benefiting from higher than expected volumes from the major multi-year deal we signed with an existing technology client in the third quarter of 2017.

In the first quarter, our Shutterfly Consumer metrics reflect a combination of effects of the platform consolidation and our more targeted pricing and promotion strategy. Total unique customers were 3.2 million, decreasing 4% over the first quarter of 2017. We generated 5.1 million orders across our portfolio of premium lifestyle brands, a decrease of 8% over the fourth quarter of 2017 and an average order value or AOV for the quarter was $29.96, a 3% increase over the first quarter of 2017.

Customers and orders decreased primarily due to the platform consolidation and a mix shift in personalized gifts and home décor away from the free product promotions. Delivering more targeted pricing and promotions helped drive higher AOV.

GAAP gross margin was 36.9% in the first quarter of 2018. Shutterfly Consumer gross margin was 44.2%, roughly flat with the first quarter of 2017, as manufacturing efficiencies and a more targeted pricing and promotion strategy were offset by product mix. SBS gross margin in the first quarter of 2018 was 16.3% down from the first quarter of 2017. The gross margin decrease comes from the major new deal signed in the third quarter of 2017, which has lower gross margins during the initial ramp period.

Operating expenses for the quarter totaled $103.2 million, excluding acquisition related charges of $4.6 million. Looking more specifically at our operating expense components, technology and development costs totaled $38.5 million for the quarter, a decrease of 16% over the prior year and decreasing 470 basis points to 19% of net revenues. The decrease was primarily due to the benefits of the platform consolidation.

Sales and marketing continued to show leverage in the first quarter due to the platform consolidation and restructuring. Sales and marketing expenses totaled $37.7 million in the quarter, a decrease of 12% and decreasing 350 basis points to 19% of net revenues. This was largely driven by more efficient external marketing spend, as we migrated our smaller brands to the Shutterfly brand and platform, which is more efficient from a marketing standpoint than our legacy non-Shutterfly brands and platforms.

General and administrative expenses for the quarter totaled $31.6 million and included acquisition related expenses of $4.6 million. Excluding these acquisition expenses, general and administrative expenses decreased to 100 basis points to 14% of net revenues.

Our operating loss for the quarter was $34.1 million. Our operating loss normalized to exclude acquisition related expenses of $4.6 million was $29.5 million, a significant improvement over the first quarter of 2017. In the first quarter, our adjusted EBITDA, which excludes acquisition related expenses of $4.6 million was $7.1 million above the high end of guidance and increasing $9 million over the first quarter of 2017.

The effective tax rate for the quarter was 35.3%. Our effective tax rate decreased 490 basis points over the first quarter of 2017. In the first quarter, the rate benefited from incremental tax deductions from stock-based compensation. As a reminder, we get the benefit of additional tax deductions based on an increase in stock price at the time RSUs vest or stock options are exercised.

Our net loss for the quarter on a GAAP basis totaled $27.2 million or a loss of $0.83 per share. Net loss normalized to exclude acquisition related expenses of $4.6 million was $23.8 million or a loss of $0.73 per share. The weighted average shares used to calculate the net loss per share totaled 32.7 million shares.

Cash and total investments as of March 31 totaled $544.4 million. Capital expenditures in the quarter were $13.2 million. In conjunction with the acquisition of Lifetouch, we raised an $825 million incremental Term Loan B which funded concurrently with the closing of the acquisition on April 2. This incremental term loan bears an interest margin of 275 basis points over LIBOR was issued at a discount at par of 25 basis points and will step down to 250 basis points over LIBOR as we lower our leverage.

Given the strong cash flow profile of the combined company, we anticipate being able to settle this $825 million term loan by 2021. As part of the Term Loan B issuance, the company received updated credit ratings which now incorporate the Lifetouch acquisition and the incremental debt. We're pleased to say that the company maintains its BB rating profile through this process, consistent with the company's stated intentions.

Pro forma for the acquisition of Lifetouch, the company now has cash and investments of approximately $550 million and debt of $1.5 billion on the balance sheet. These debt and cash balances include the company's $300 million convertible notes which are coming due on May 15, 2018. The company intends to settle the $300 million par value of these convertible notes in cash. Please note that the company has an existing bond hedge, which will offset dilution from the conversion features of these notes.

Separately the company has an outstanding warrant with approximately 4.7 million shares underlying, which will settle starting on August 15 ratably over the subsequent 80 trading days. The company can settle the warrant in shares or in cash. As a reminder, we anticipate paying down our acquisition debt and maintaining a BB rating profile. From there, we'll continue to focus on optimizing capital allocation across organic reinvestment in the business, further M&A and returning excess capital to shareholders.

Now, I will turn to our updated financial guidance. The acquisition of Lifetouch will significantly increase our overall profitability. Since the acquisition closed on April 2, we have updated our guidance to include Lifetouch. Our Lifetouch annual guidance is consistent with the communication we provided in January when we announced the deal, except for the impact of exiting the iMemories business in the second quarter, which reduces our FY 2018 revenue guidance by $22 million but has no impact to adjusted EBITDA.

We have provided a bridge from our previous communications to our new guidance in both the appendix and accompanying the presentation to the webcast and our earnings release. Today, we are providing updated annual guidance for the combined company, as Lifetouch previously operated as a private company, historical GAAP quarterly financials have not been prepared. As such, in an effort to help our investors better understand the seasonality and profitability of the combined companies, the company is providing quarterly targets for each quarter of 2018 that sum to the midpoint of our annual guidance. Please see the presentation accompanying this webcast and our earnings release for further detail.

We are providing annual guidance on both a GAAP and a non-GAAP basis. Our non-GAAP guidance includes estimated purchase accounting adjustments related to adjusting property and equipment and intangible assets to fair value, but excludes non-recurring and non-cash adjustments related to inventory in deferred revenue. We believe this non-GAAP guidance will provide investors important information on trends in our business on an ongoing basis. There is a full reconciliation contained in our press release.

There are a number of items to note related to the 2018 GAAP and non-GAAP guidance that I would like to highlight. First, since the acquisition closed on April 2, the first quarter revenue and adjusted EBITDA for Lifetouch are not reflected in this guidance. Lifetouch typically has revenue of approximately $128 million with an adjusted EBITDA loss of approximately $30 million in their first quarter, as it is the seasonally smaller quarter for the Lifetouch business.

Second, we expect to complete purchase accounting in the second quarter of 2018. The guidance and targets we are providing today reflect our best estimates as of this moment in time. These estimates relate to normal purchase accounting adjustments that require the opening balance sheet to be fair value.

The first adjustment relates to deferred revenue. Deferred revenue will be written down to fair value. This will have the effect of lowering GAAP reported revenue by approximately $40 million in 2018, most of which we expect to occur in the second quarter. Non-GAAP guidance will adjust for this deferred revenue write-down.

The second relates to inventory. Inventory will be written up to the fair value and have the effect of increasing cost of revenues by approximately $15 million in 2018, again, most of which we expect to occur in the second quarter of 2018. Non-GAAP guidance will adjust for this cost of revenues increase also.

The third relates to property and equipment. Depreciable property and equipment are expected to be valued at approximately $145 million and will have a weighted average length of 11 years resulting in annual depreciation expense of approximately $13 million.

And lastly, intangible assets are expected to be approximately $300 million with a weighted average life of seven years resulting in the annual amortization of approximately $43 million. None of these estimated purchase accounting adjustments will impact cash flow or adjusted EBITDA.

With all that said, here's our non-GAAP annual guidance. Non-GAAP revenue, we expect to range from $2.01 billion to $2.06 billion; Shutterfly Consumer revenue to range from $1.02 billion to $1.05 billion; Lifetouch nine-month non-GAAP consumer revenue to range from $780 million to $790 million; SBS revenue to range from $210 million to $220 million. We expect a non-GAAP gross margin of approximately 62.4%; non-GAAP operating income to range from $185 million to $206 million; adjusted EBITDA to range from $390 million to $410 million; and non-GAAP earnings per share to range from $2.83 a share to $3.28 a share. We expect capital expenditures to be approximately $100 million.

Lastly, I'll note that this guidance excludes remaining acquisition related charges of $7 million, as well as $4 million of charges related to exiting the iMemories business.

Now, we'll open it up for questions.

Question-and-Answer Session

Operator

Thank you. We will now begin the question-and-answer session. And the first question comes from Youssef Squali with SunTrust. Please go ahead.

Naved Khan - SunTrust Robinson Humphrey, Inc.

Yeah. Thanks. Thanks a lot. This is Naved Khan for Youssef. I had a couple of questions. I think the guidance bridge is very helpful, just wanted to get some incremental color in terms of the EBITDA contribution from Lifetouch. I guess your guidance – the old one, the one you gave back in January and even this one, both kind of contemplate roughly $20 million to be spent on integration of Lifetouch. Can you just speak to specific areas where you will be focusing on as you look out now that you have completed the acquisition? And then I have a follow up.

Michael W. Pope - Shutterfly, Inc.

Yeah. I think – this is Mike. I think back in January when we announced – end of January when we announced the acquisition, what we said is in the first 12 months following the acquisition of Lifetouch, we expected them to contribute $935 million of revenue and a $100 million of adjusted EBITDA and that reflected the cost that we would also incur related to integrating Lifetouch and Shutterfly together, offset positively by some of the synergies that we expected to get over the course of 2018 in the near term, which are largely related to the operations side and supply chain in particular.

Naved Khan - SunTrust Robinson Humphrey, Inc.

Okay. And in terms of just the opportunities with respect to maybe facility consolidation, do you think that – do you see any opportunity? Do you think that's 2018 or further out? And then, on the core, I guess, the 10% growth in the Shutterfly brand is that looks pretty good. Do you think that's a sustainable pace as you sort of lap the platform migration and enter Q4, and then, 2019, how should we be thinking?

Michael W. Pope - Shutterfly, Inc.

Yeah. Let me take the first one as it relates to what you refer to as some of the cost synergies, I think in particular you referenced facility consolidation. I think as we said in some of our prepared remarks, both the Lifetouch team as well as the Shutterfly team are working jointly to look at the opportunities that we see for cost synergies as well as frankly revenue synergies. And so, we have teams on both sides working on that.

I think near term, what we see in 2018 relates to supply chain. I think longer term, what we said before is that some of the opportunities that we see further on the operations side are driven by complementary technologies where they're strong in those silver halide and we're strong in digital printing.

Christopher North - Shutterfly, Inc.

Hi, Naved. This is Chris. I'll take your second question about the growth of the Shutterfly brand, the organic growth, and I'm certainly pleased to see that growth in Q1. I think for context I'll add that we provided targets for 2018, which imply a 10% Shutterfly Consumer growth rate in Q4 and, of course, when we're in Q4, that will be a like-for-like comparison to the prior year for the first time. So that does imply a year-over-year acceleration versus the Q4 2017 Shutterfly organic growth rate of 7% and that comes about, as we continue to execute against our strategic growth initiatives.

I think with respect to the Q1 growth, the one thing I'd say is I just remind you that Q1 is a pretty small quarter for us and we're pleased with those results. They are also supported by our first Q1 in which we had the Shutterfly Wedding Shop, which we launched in Q3 2017, certainly pleased with how that's performing so far.

Naved Khan - SunTrust Robinson Humphrey, Inc.

Okay. That's very helpful And then, one quick follow-up if I may. I guess you spoke to this on the call about sort of defining the promotional activity, but how does it affect the loyalty rates and the propensity of consumers to come back just because they're more engaged?

Christopher North - Shutterfly, Inc.

Yeah. It's a great question. I mean, the way we think about our promotional strategy overall is that we – it's kind of two ways. One is we ultimately want to be maximizing the long-term value of every customer and secondly that increasingly we want a better thinking about it as targeted a way as possible even down to the level of the individual. I'm not claiming that we're that good today, but over the next few years, that's where we're going.

And so, what you saw in Q1 is a continuation of the refinement of both our promotional strategy and our targeting. And what we were able to do in Q1 is to refine the targeting of our most aggressive promotions, the free promotions in a way that we think is the right thing to do for the business. And we were more targeted offering those promotions to the customers who are most likely to respond to them.

So we think this is the right thing to do for the business long-term, both at an individual customer level, but also in terms of ensuring we're driving not just growth, but profitable growth. You did see it in Q1 that it will be to lower growth in the free products in the personalized gifts and home décor category. At the same time, we saw very strong growth, in fact, our strongest in two years in paid personalized gifts and home décor business.

Naved Khan - SunTrust Robinson Humphrey, Inc.

Very helpful. Thank you, Chris. Thank you, Mike.

Christopher North - Shutterfly, Inc.

Thanks.

Operator

Okay. The next question comes from Kerry Rice with Needham. Please go ahead.

Kerry Rice - Needham & Co. LLC

Thanks. Tremendous quarter, guys. Couple of questions, maybe first on the guidance for SBS, it looks like you've moved that up a little bit. Is that again just the contribution from the major contract win in Q3 of 2017 or are you looking for some additional large wins as we move through 2018? That's the first one.

Second, I think your previous CapEx guidance is about $65 million. I don't know if that includes Lifetouch. So with Lifetouch, does that add the extra $35 million or is there something else you're kind of planning to do there?

And then, finally, maybe, Chris, could you talk a little bit about the competitive landscape? I don't know if you can just walk through each of those businesses if we have time, that would be great. If there's any changes there, that would be helpful. Thank you.

Michael W. Pope - Shutterfly, Inc.

Why don't I take the first two, Kerry? Thanks. With regard to the guidance for SBS, I think first what we've generally said on SBS is we tend to plan and provide guidance for what we have direct line visibility into. And so, I think if you look at the guidance, we raised that slightly what we said back in January and that was driven by an outperformance in Q1 as well as what we anticipate to be a little better than we expected in Q2.

And you are right that that is largely driven by bringing the large technology existing clients on faster than what we had anticipated. You also note just to sort of complete the thoughts that our guidance for the second half of the year is for that business to be slightly down in the second half, but still higher than what we had planned on a full year basis and that's because of the second half of the year, you remember last year in Q3 and Q4, we brought on that client more quickly and pull forward some of that revenue.

The same thing with regard to CapEx, it's pretty simply answer, $65 million was on a Shutterfly standalone basis and when we add in Lifetouch, that adds about $35 million, so that brings it to the total of $100 million for our guidance for the full fiscal year 2018.

Christopher North - Shutterfly, Inc.

And Kerry, on your third question on competitors, I guess I always said that we really haven't seen any meaningful changes in the competitive landscape within the Shutterfly Consumer business that there continued to be a range of smaller competitors who are out there and haven't really seen a change in their strategy or a meaningful change in the degree to which they are promotional or competing on price.

I think there's always a level of interest on these calls about what some of the bigger tech companies like Amazon and Google are doing. And again, I'd say the situation seems unchanged there to the extent that they have made inroads. It's not something we're able to identify within our business results and of course, they don't break out their numbers for their photo-related businesses.

In SBS, we continue to be virtually unique out there in the marketplace in terms of our offer. There certainly are a range of large traditional commercial printers typically coming at it from the offset angle as well as some relatively small digital specialists who tend to be very industry specific. But I think we're almost unique, if not unique in our ability to deploy the world of artists and best four color digital printing platform on behalf of business. And so, when it comes to businesses, we're looking for either one-to-one personalization or just in time inventory free printing, but it will also have the needs for our scale. I think we have an unique offering there.

And with respect to Lifetouch, Lifetouch is really by far the leader in its business. Its competitors tend to be small independents that are a fraction of its size. And again, we haven't seen any meaningful changes in the time that we've been observing the company there.

Michael W. Pope - Shutterfly, Inc.

And I'd highlight, I'd go further, Chris, to highlight that in the fall season, which is their most important season, they actually saw a small uptick in that business for the first time in our recent history.

Christopher North - Shutterfly, Inc.

Yeah, that's right. And I think the team themselves have identified that they really think that, and their business is all about great execution. We've certainly seen this management team executing well over the time we've been with the company.

Kerry Rice - Needham & Co. LLC

All right. Thank you so much for the insight.

Operator

Okay. The next question comes from Victor Anthony with Aegis Capital. Please go ahead. Okay. The line of Victor Anthony with Aegis Capital is now open.

Victor Anthony - Aegis Capital Corp.

I'm actually here. Sorry, guys. Just checking in a few calls. Two questions. One, it looks like there, I guess $30 million in additional EBITDA for their full year. Is that I guess all Lifetouch? Looks like it is. And a follow-up to that, your guidance for 2020 presumes to be kind of a huge element of conservatism built in there. Maybe, I just want to get a sense of how comfortable you are with that guidance now that you've closed the acquisition, and also maybe if you could just give us an update in terms of how the integration process is going.

And the second on the core business, just a follow-up I guess to some of the questions I heard on the promotions and the competitive environment. There were just free promotions that you talked about. Is that a testament to – I know you just talked about the competitive environment just now – but to the fact that you're just not too concerned about the competitive environment now that you feel comfortable reducing these free promotions?

Michael W. Pope - Shutterfly, Inc.

Yeah, sure. So Victor, thanks for the question. I think just a clarification. The contribution from Lifetouch to our EBITDA for 2018, we are not raising. We are keeping it consistent with what we said in January, though mathematically, we've had the benefit the fact that we didn't own Lifetouch for the first quarter of 2018. And in the first quarter of their year, they lose $30 million on an EBITDA basis. So I think we're very consistent there.

And that leads into your second question which was our 2020 minimum $450 million EBITDA target. I think we remain very comfortable with that. I think we provided the details as to how you can roadmap to that by 2020 if you took the midpoint of the Shutterfly guidance back in January of $270 million, the $100 million contribution from Lifetouch gets you to $370 million. We indicated that with a modest 5% growth in EBITDA over two years for that combined company, that's roughly $40 million, gets you to $410 million. And then lastly, we continue to see opportunities on both the revenue and cost synergy side that we think could be $50 million by 2020. So that puts you over the $450 million target of EBITDA.

Christopher North - Shutterfly, Inc.

And then, Victor, I'll take your last question about the core and I say, no. Really, the competitive environment haven't changed as far as we can measure, neither more nor less competitive. Our ability to begin reducing to some extent our dependence on free promotions has really come from better targeting. And just anecdotally – I'll share an anecdote that comes out a lot of testing and analysis.

What we discovered is that there's only a subset of our customers who respond to these free promotions. Those who do tend to really love them. But there's another set of customers who seem completely uninterested and they're interested in paid products. And what we've been able to do is to refine our targeting to focus the free offers and those customers most likely to respond to free offers and to focus paid offers and other types of promotions on those customers more likely to respond to those.

And so, just think about it as a step in the direction of a vision of reaching each customer with the ideal marketing terms at the right time for that customer and not a response to any change in the competitive environment.

Victor Anthony - Aegis Capital Corp.

Yeah.

Michael W. Pope - Shutterfly, Inc.

Victor, I think the fourth question you asked was how is the integration going so far. And I think we're very pleased with the integration. I think we're taking a measured approach, we put resources against it on both the Shutterfly side and on the Lifetouch side, and it's progressing nicely.

Christopher North - Shutterfly, Inc.

The only thing I'd add Mike is I just want to emphasize that we're taking a very measured approach to the integration and our first principle that we've assigned to ourselves with the integration is to ensure that we are supporting the success of each business as a independent business and not doing anything that could endanger, for example, the core selling season for the fall Picture Day for Lifetouch.

And the second principle has been to focus our energy on a small number or the largest opportunities. So what you're going to see from us this year is a lot of our focus is around on the comp side on supply chain, given that the Lifetouch ball picture day selling already we'll start as early as July for some schools. You will be relatively limited in the integration that we try to do on the experience that customers have there, but we'll have a lot of more opportunity when we get into 2019 and, of course, 2020 to build towards what we think is the best possible experience for Lifetouch customers.

Victor Anthony - Aegis Capital Corp.

Okay. Thank you.

Operator

Okay. The next question comes from Christopher Merwin with Goldman Sachs. Please go ahead.

Christopher Merwin - Goldman Sachs & Co. LLC

Hi, great. Thanks for taking my question. I just had a couple of ones. First, for SBS margins. I think they were down about 750 basis points year-on-year, can you just remind us why initially they're declining and how we should think about the pace of recovery for those margins over time and what specifically is going to drive that.

And then, the second question is relating to the $50 million in synergy guidance. Can you break down for us what is cost and what is revenue, and then, just in general, help us think about the components of Lifetouch's cost structure, what's the gross margin of that business, how much does Lifetouch pay to photographers, just really what part of their cost structure is variable, and then, what are sort of the fixed pieces of that cost structure that could potentially be eliminated in the context of the synergies that you've guided to? Thank you.

Michael W. Pope - Shutterfly, Inc.

Sure. So with regard to the SBS margins, they're down. They're not outside of where we thought it would be. As we said, I think in both Q3 and Q4, we onboarded a large client, a new program for an existing technology client that in Q3 and Q4 and we continue to onboard portions of that program as we go through 2018. Often when we bring the new program onboard, it starts out at lower margins and we're able to build those margins over time. So that's what's driving the SBS margins.

That margin on our client is lower than what our typical margin would be, as we've said in the past, but ultimately, we're excited about the opportunity that we have to continue to leverage the manufacturing platform that we have. And I think the last, as we also said in the past, we tend to think about this as an incremental EBITDA dollar business as opposed to being solely focused on margin percentages.

Christopher North - Shutterfly, Inc.

I think there is also – the end of Chris' question was about when will you expect to see some margin improvement under that deal?

Michael W. Pope - Shutterfly, Inc.

Sure. So we will start to see margin improvements on that large technology client in the second half of the year.

Christopher North - Shutterfly, Inc.

Okay. And Chris, I think your earlier questions were around the synergies, how they broke down between cost and revenue and just to talk a little bit about which parts of the Lifetouch cost structure or indeed the shared company's cost structure were touched by the synergies. So in terms of the 2020 target that we've given for $50 million of combined synergies, that comes – $50 million adjusted EBITDA contribution from the client synergies that comes roughly half and half from cost and revenue synergies.

On the cost side, we're very focused in particular on the benefits of the combined companies' scale and the shared manufacturing platform since the companies have very complementary manufacturing capabilities, as well as adjacent and complementary seasonality. So the largest part of the cost synergy that we see over the period come from the supply chain side where we get savings from our scale and from operating a shared manufacturing platform. Within that, there are both fixed and variable components to the savings.

You mentioned photographers. I mean to be clear, Shutterfly doesn't use professional photographers in any part of our business. So that is really just a cost that is incurred as part of the Lifetouch cost structure and it's not something where we see particular synergies from the integration.

Christopher Merwin - Goldman Sachs & Co. LLC

And any way to quantify like what percentage of sales those photographer costs are?

Michael W. Pope - Shutterfly, Inc.

We are not.

Christopher Merwin - Goldman Sachs & Co. LLC

Okay. All right. Thank you for those answers.

Operator

Okay. This concludes our question-and-answer session. I would like to turn the conference back over to Christopher North for any closing remarks.

Christopher North - Shutterfly, Inc.

Great. Well, thank you very much for joining us for those questions. When we looked back over Q1, we're obviously pleased with the results that we've delivered in particular from the healthy organic Shutterfly brand growth, the significant year-over-year improvements in profitability and the SBS growth.

We're delighted to have closed on this transformational acquisition of Lifetouch and very excited about what that means for the combined company going forward. And when I sit back and look at where we are on our journey, I really think you can divide it into a couple of phases. And the first phase is I think we completed last year in simplifying the Shutterfly Consumer business and articulating a clear strategy over the next few years and putting up with the operational process and financial disciplines that will enable us to scale and not incidentally delivering significant financial improvements.

I think we're now in the second phase of that journey. I think that really is going from this year through 2020 during which our focus will be around of course integrating Lifetouch realizing these very significant cost and revenue synergies. At the same time, we'll reaccelerate the Shutterfly Consumer growth and continuing to leverage our digital manufacturing platform on behalf of other businesses.

As we get through that phase and begin to repay the acquisition debt, I think we come to a sort of third exciting phase where we'll increasingly have opportunities to drive shareholder value creation by optimizing capital allocation across three or among three different uses of capital. Organic reinvestments in these businesses, continued M&A, but of course, also returning excess capital to shareholders. So we're really excited about what's ahead and just want to thank all of you.

Operator

Okay. The conference is now concluded. Thank you for attending today's presentation. You may now disconnect.