Description

Summary

We believe SFLY presents a very attractive risk/reward profile at its current price, with over 40% upside to our price target of $63.50 (based on 8% 2018 FCF yield plus net cash, implying 7.6x ’18 EBITDA) and fundamental downside of ~10% (based on a 10% 2017 FCF yield plus net cash, implying ~6.0x ’17 EBITDA).  After a 15% sell off on 4Q’16 earnings, we believe the current share price represents an attractive opportunity to invest in a company with a strong brand, dominant market share, and best in class manufacturing in its core business; dramatically improving ROIC under leadership of a new CEO; an under-utilized balance sheet; and an attractive enterprise growth opportunity.  Currently trading at ~7.0x ’17 EBITDA and ~6.0x ’18 EBITDA and a double digit 2018 FCF yield, we believe there are very few opportunities in this market to invest in a company at similar multiples that will grow FCF / share at a ~25% ’16-’18 CAGR.

Recent events

Aviaclara181 wrote up SFLY in November 2014, which provided background on the company and a good state of affairs at that point.  The following is an update since that time:

• Marathon Partners led a successful activist campaign in 2015 versus SFLY, resulting in gaining 2 boards seats (one has subsequently been vacated), and more importantly ending up in the company parting with the incumbent CEO (Jeff Housenbold) after turning down PE bids in the $50 range for the second time in 2 years

• In March 2016, Shutterfly announced the hiring of Chris North as CEO effective June 2016.  North led Amazon UK previously, and some more background on him can be found here:  http://www.standard.co.uk/business/markets/christopher-north-amazon-s-uk-chief-is-delivering-the-goods-10235771.html

• North’s first few months on board were somewhat of a fire drill, getting up to speed and trying to prepare the company for the crucial fourth quarter (nearly 100% of EBITDA generated in 4Q) amidst significant management turnover (COO left in Feb 2016, CFO relatively new)

• Fourth quarter 2016 results were below the street (missed by 4% on revenue and 6% on EBITDA), driven by weakness in the consumer segment, particularly high end consumers at the core Shutterfly brand.  We believe this was driven primarily by execution (ineffective selection and promotions at the high end) and not incremental softness in the category.  We believe the execution challenges were somewhat of a function of the turnover in management in 2016, and while certainly should be monitored, are likely to be transient.  While previous management were atrocious allocators of capital, they were relatively competent at operating the business around the all-important holidays, and we do not believe that a slight hiccup after a few months of operating the business is evident of broader issues with the new team

• More importantly in the 4Q’16 release and on the call, management announced a significant restructuring of SFLY’s operations and a pivot to the company’s new strategic plan.  We discuss the details of the plan further below, but these changes essentially aim to correct the poor capital allocation decisions (shutting down or selling tertiary brands / segments) by previous management while positioning the company for growth within its profitable lines of business.  The restructuring resulted in the company announcing 2017 EBITDA guidance 15% below the street estimate (and 2018 EBITDA 5% below the street), and led to a ~15% decline in the stock price after the print

Restructuring results in dramatically improved return metrics

As we noted in the update, the previous management team was historically poor at capital allocation, and their compensation was such that they were incentivized at growing topline and absolute EBITDA $ without regard for profitability or returns.  Unsurprisingly, this led to poor acquisitions and a refusal to shut down money losing/poor return segments within the company, resulting in a business that earned well below its cost of capital and consistently disappointed shareholders on promises of harvesting prior investments.

The announced restructuring runs essentially what would have been the private equity playbook from a cost cutting perspective, but in a public setting.  The key points of the restructuring, which will take place over the first 3 quarters of 2017, include:  

• 13% headcount reduction (~260 employees)

• Retiring the MyPublisher brand and shutting down TripPix, FavPix, and Shutterfly Pro Gallery

• Consolidating onto a single technology platform, with the entire experience driven through Shutterfly.com, with a boutique for Tiny Prints for premium cards / stationary, and post-transition decommissioning the Tiny Prints, Wedding Paper Divas, and MyPublisher websites

• Selling BorrowLenses

• $15-$20m of restructuring charges in 2017

• 300bps reduction in Sales/marketing expense as % of revenue by 2018

Resulting in:

• $40m improvement in GAAP gross profit in 2018

• $50m improvement in adjusted EBITDA and GAAP operating income in 2018

• Flat YoY capex in 2018 of $75m

A comparison of reported results and our projections for 2014 / 2016 / 2018 highlights the dramatic improvement in returns that management hopes to effect with this restructuring:

This above analysis does not assume any write-down of goodwill (which is possible given the ongoing restructuring) or reduction in the tax rate, both of which could materially improve 2018 returns.  ROIC improvement should continue after 2018 if management can execute its plan and results in a company earning well above its cost of capital after years of destroying value.    

Balance sheet upside

While the majority of the market has used financial engineering to support share prices given low interest rates, SFLY has left its balance sheet capacity generally untapped, continuously citing they require flexibility to both deal with a $300m convert that is due in May 2018 and dry powder should any interesting assets come available.  While previous management had little incentive to focus on the stock price, the new CEO’s comp plan (and now all of senior management’s) is weighted toward stock options, better aligning them with shareholders.  We believe this may result in a greater willingness to be more aggressive with the balance sheet to buyback stock, which would be extremely accretive at these levels.

We believe that banks were willing to lever this business ~5x in a take private as recently as early 2016, and while that type of leverage would likely be irresponsible for a public company with SFLY’s operating profile, we believe a leverage target of 1.5x or even slightly higher would be very appropriate, and SFLY could put a credit facility in place allowing them to do so at very attractive terms given current credit market conditions.  Taking net leverage to 1.5x and using additional leverage capacity and excess FCF to buyback stock could dramatically increase FCF / share over the next few years, as seen below:

We believe many current shareholders are onboard with / communicating they support enhanced use of the balance sheet to repurchase shares, particularly where the stock is today.  Using an 8% FCF yield on the pro forma FCF/share illustrates the impact an aggressive buyback could have on the stock price, and we do not believe the implied EBITDA multiples are unreasonable in these cases given both the more shareholder friendly capital allocation policy and increasing the debt/equity ratio would drive the company’s cost of capital lower than current levels.  While we believe there is significant upside to the current share price without optimization of the balance sheet, this provides an upside case should management and the board choose to more aggressively return capital to shareholders.

Enterprise growth opportunity

Shutterfly Business Solutions (SBS) sales nearly doubled in 2015 and grew by ~40% in 2016 to $137m for the year, or 12% of total revenue.  While SBS is a lower gross margin business than consumer (2016: 26% versus 54%), we believe that this is an attractive way to drive gross profit dollars through otherwise idle machines during the first 3 quarters of the year when the factories are operating well below peak capacity.

Management provided SBS guidance for 2017 and 2018 of 20% revenue growth, implying the business will approach/exceed $200m in sales by 2018.  We believe Shutterfly’s flexibility and scale make it an optimal partner for enterprise companies that market via direct print advertising, and the growth and stickiness of this business has consistently outperformed expectations.  We believe that management’s forecast for 2017-2018 is conservative, and there is potential for further step function growth in this multi-billion dollar enterprise printing market (which management indicated currently has only 10% digital penetration) given the investments in improving the SBS platform.  Management noted on the call:   

• “the SBS growth has not been constrained by market opportunity or our ability to generate a customer pipeline. If anything, we've deliberately slowed down customer acquisition or expansion into new verticals because our business model today has required us to do a lot of dedicated systems work for each new customer we bring on. The work that we've done in 2016, and that we continue to do in 2017 to turn SBS into a true platform means that as time goes on, we'll be able to add additional customers with much less dedicated incremental work for each customer. And that will start to allow us both to go after more customers in the existing verticals that we already serve, and to expand to other verticals as well”

After the investment discussed above, the company should generate better returns/margins on new customer wins in 2018 and beyond.  The more efficient onboarding structure should also allow the company to target smaller enterprise jobs (and still generate acceptable returns), significantly expanding the addressable market beyond just the largest Fortune 100 companies they are working with today.  

In our base case, we are forecasting slightly above the 20% growth over the next 2 years that management guided to.  We believe this to be conservative and that the improved SBS platform should allow SBS to grow in excess of guidance in the medium term, which is further upside to our base case / consensus estimates.

Forecast model

The model below is not dramatically dissimilar from consensus in 2017-2018 for revenue and EBITDA. We view this as a conservative base case, not including a more significant buyback or upside to what we believe is a low bar for SBS growth.  However, given the history of this company (before management changes) over-promising and under-delivering on longer term targets, we believe the buyside is unwilling to underwrite the management case for 2018 / does not believe in current consensus estimates.

Valuation (per our base case forecast)

Our price target is based off of an 8% FCF yield and also implies a 7.6x EBITDA multiple, which we believe is reasonable and within the range SFLY has recently traded.

We also ran a 10 year DCF to sanity check our price target.  Assuming ~3% perpetuity growth and a high single digit WACC (8%-10%), and treating all the stock based comp as a cash expense, it is not much of a challenge to arrive at intrinsic values at a significant premium (over $60) to the current price.  2 years ago under previous management, it was hard to produce a defensible forecast that resulted in intrinsic values significantly above $50 (if treating SBC as a cash expense), even with higher growth assumptions then.  However, we believe the material reduction in stock based comp, recently announced restructuring/margin improvement, and reduced capital intensity significantly increase the long term intrinsic value of the SFLY.

While we are not basing our investment thesis on multiple expansion, we do not believe it would be a stretch to argue that a company growing FCF / share at a 25%+ CAGR for the next 2 years could trade at a materially lower FCF yield than 8%.  Applying more aggressive FCF yields on our base and buyback case give an indication of what upside scenarios could look like for SFLY given some modest multiple expansion:

Event path

• Execution of the restructuring over the next few quarters – we believe if new management can establish credibility with investors, then the 2018 story will start getting priced in (vs. little to no credit in the stock today for newly announced strategic plan)

• Refinancing the convert – putting a term facility in place could provide balance sheet stability and allow for more aggressive repurchase activity

• New category announcements – while we do not expect these to be imminent (more likely back half of 2017), we do believe that by 2018, there will be much better clarity on the adjacent verticals management plans to expand into and the relevant potential addressable markets to improve growth within the consumer segment

• Sell side catching up – if management is able to execute and the stock appreciates (particularly if a material buyback is announced), sell side sentiment, currently fairly negative, will shift resulting in materially increased price targets as analysts update their models and change valuation inputs so they can point to further upside in the stock

• We believe that if management’s strategy fails to generate material appreciation in the stock, the company can ultimately be sold.  Private equity has shown interest in the past and banks have been willing to underwrite significant leverage in a deal, and we believe there would be broader PE interest now vs. under previous management as a buyer would no longer be forced to either keep Jeff Housenbold or pay his ridiculous $30m termination provision on a change of control

Risks

• Restructuring execution: Management is attempting to transition potentially its most valuable customer (premium customer = higher AOV and gross margin) onto the Shutterfly platform from Tiny Prints, Wedding Paper Divas, etc.  There is likely to some be disruption in the process which could make near term results volatile

• However, we believe the cushion in guidance is substantial.  If the model assumes SBS growth at 20% (per guide) and at a high level, the core Shutterfly brand was ~$700m of sales in 2016, and if management can continue to grow Shutterfly brand at 5% (4Q’16 was MSD growth at SFLY brand), then guidance bakes in the ability to lose up to 20% of the businesses they are migrating over and still hit the bottom end of the sales guide

• Mobile monetization: mobile has grown significantly within Shutterfly, accelerating with the introduction of a new app in 2016, and accounted for 18% of revenue last year.  However, mobile orders are lower AOV than desktop, making it harder to sustain/expand gross margins as more business shifts to mobile

• Management has noted that customers who have adopted the mobile app have spent more with Shutterfly than they did before downloading the app.  Increased annual revenue per customer will help offset the drag of lower margins from a returns standpoint (essentially higher inventory turns offsets lower gross margin).  Management also noted that the app has allowed them to acquire new customers that were previously not with Shutterfly when it was desktop or mobile site only

• Elephants in/entering the room (Amazon / Google / Facebook / Snap): Amazon introduced a photo printing service in September 2016, sending SFLY stock down 10% on the day of the announcement.  Shutterfly management believes that in this test of printing services, Amazon (or anyone else looking at entering this business) will realize it does not generate sufficient returns without owner’s economics.  However, depending on the ultimate motives of any of the companies mentioned, losing money is not something they are necessarily adverse to, so their entry into the space in a material way remains a risk

• Category slowing: management noted that the core consumer digital printing business has slowed to LSD-MSD category growth.  SFLY has been able to outgrow the category over the last decade due to market share gains, but now as the dominant player (~7x the size of the next largest player), share gains are harder to come by.  While more pictures than ever are being captured digitally, if the consumption is increasingly only through Instagram/Facebook/etc., Shutterfly will have a hard time growing

• Lack of imminent catalysts: given that nearly 100% of EBITDA is generated in the fourth quarter, estimates are unlikely to change materially over the next few quarters.  However, we believe that the current risk/reward profile is too compelling to ignore and that the potential for capital structure transformation could lead to material upside prior to improving returns getting priced into the stock

Catalyst

See Event Path section above