Description

Shutterfly is the leading player in the online photo print market, with a concentration on Personalized Products & Services (ie:  photo books, personalized stationary, calendars etc.)  The company's growth prospects have been historically highly correlated with consumer confidence - but have also been impacted by market share shifts in this highly competitive industry.  SFLY has a leading 35% market share in the industry, with Snapfish (HP) and Kodak Gallery (Kodak) at roughly 30% and 24% respectively.   In the past 2 years, Shutterfly has increased its share from 33%, while Kodak has lost significant ground from a 31% share in 2007 and Snapfish at 19%.   Despite the weak economy, SFLY has continued its growth throughout the recession - growing revenues 14% y/y in 2008 and on pace in 2009 to grow 8%.  Shutterfly has focused on being the premier provider in the space, offering more innovation, higher quality products and producing and developing all products in-house, unlike its competitors.  This allows for a low cost advantage for SFLY making them the only cash flow positive player in the sector.  Snapfish, and Kodak more recently, have focused on the more commoditized end of the market and competed aggressively on price and with other promotions.   Recent moves in the competitive landscape combined with general concern around the macro environment has created some unwarranted dislocation in the shares of the company.

Despite the stock move of >100% off the lows, , it remains highly undervalued relative to the growth opportunity ahead, both on an EBITDA and FCF basis.  Earlier this month, they beat street estimates, growing the top line in Q3 north of 13%, acceleration from 9.6% in Q2.  The operating trends underlying their business show that growth in the personalized products and services (PP&S) segment - the growth engine - were up 22% in the recent quarter.  The company issued conservative guidance for Q4, describing their trepidation around the consumer spending environment going into the holiday season.  Management has not seen anything in October to lead them to believe the strength from Q3 will not continue.  Historically, management has guided the street cautiously, and consistently beaten estimates.  Their comments around the conservative Q4 guidance echoed what they had said on the Q2 call as well - while they feel good about their positioning, they are providing overly conservative guidance because their macro visibility is lacking.  Sell side analysts have heavily discounted the growth potential and differentiation that Shutterfly offers, and the company is well positioned for sell side upgrades going into 2010.  In our opinion, several key initiatives at the company are in place to offset consumer spending weakness in Q4 - which comprises >50% of annual revenues - and accelerate growth in 2010 and beyond.  Investments in a new Phoenix production facility, continued growth in Share Sites targeting families, youth sports teams, and schools, consumer adoption of photo books driven by simplified book making tools all should help drive top line growth while at the same expanding margins.

Personalized Products 

The company has been experiencing a product mix shift from typical 4x6 prints to Personalized Products - primarily photo books and designer cards and stationary.  The Average Order Volume (AOV) has steadily been increasing over the past few years from under $26 in 2007 to over $30 this year.  Personalized Products now comprise 58% of revenues.  As awareness of photo books and ease of use in creating them continues to improve, we expect that mass market consumer behavior will continue to shift from individual prints to the adoption of professionally bound coffee table quality photo books as a visually desirable, simple, and affordable method to display photographs.  Currently, the photo book market is roughly $500-$600 mm, a fraction of the $15 bn print market, leaving a long path of growth through mass market adoption.  This year, the industry will develop about 450 million 4 x6 print transactions versus the 8 or 9 million photo book transactions that are expected to a occur.  In Q2, the company lowered the entry price point for photo books - introducing soft covered book options for 8x11, 5x7 and 7x9 photo books.  Price points now, start as low as $12.99, and vary by format, size, cover (hard/soft), # of pages.  In late Q3, SFLY launched its Simple Path tool - which allows users to create photo book in under 10 minutes, reducing the barriers to entry for those that historically have been challenged by the time and technical expertise it may take to create an online photo book.  On the Q3 call, management discussed the early success that they are seeing from this new product - and the hope that eventually this higher margin, higher ASP product will cannibalize all 4x6 prints.  The strength in photo books in Q3 was the key driver of the strong revenue growth, with the Simple Path tool incrementally adding new photo book customers, as opposed to cannibalizing current photo book customers using the more customized method of creating higher end books.  Consumers are using Simple Path photo books as entry points into this new format, and then, once adopted, they will move to higher priced books.   

In Q2, the company launched new designer stationary products.  The stationary business, similar to the photo business has traditionally been purchased offline, with over $7.5 bn in stationary and cards purchased annually.  Online, this has continued to be a fragmented immature market.  SFLY has been making inroads, growing this business at healthy double digit rates the past few quarters as they continue to enhance the offering.  They have enlisted various designers, various formats for all occasions, and 800 new holiday designs to push in Q4.  They recently launched their direct mail service - where the company addresses, stamps and mails customers holiday cards directly from the manufacturing facility.  They have also partnered with various charities to create cards allowing customers to offer donations as holiday gifts.  This is a growing portion of the Personalized Products segment, and we believe will be an important driver of growth moving forward. 

Commercial Printing

Because of the seasonal nature of the consumer printing business, production capacity is underutilized from Q1-Q3.  In an attempt to even out the company's seasonality, and add revenue at little incremental fixed cost, the company has recently entered the commercial printing business.  YTD, they have generated $2.7 million in commercial revenues, ramping from $700k in Q1 to $1.2 m in Q3.  In the most recent quarter, they had 14 customers, 8 of which were new.  The work being targeted focuses on custom work and avoids the commoditized offset printing side of the business.  They have hired 4 salespeople and within 3 years believe this could represent a $30 - $40 million revenue opportunity.  SFLY has not included any commercial revenue in their guidance.  This should be incrementally positive for margins and cash flow, as margins run around 20% at scale, with no capital investment needed.   

Shared Sites

In 2008, Shutterfly launched Share Sites - allowing consumers to create online communities to share pictures, videos and other content.  The platform includes enhanced social media functionality including blogging, photo and video sharing, self-publishing and integration with other platforms.  This is a key initiative which we believe will provide several benefits to the company.  This free product is targeted at families, sports teams and schools initially, and is being marketed both at a grass roots level as well as online.  The key purpose is to drive customer acquisition, product sales and to a smaller extent advertising opportunities.  Adoption so far has been extremely strong, with over 1.5 million sites created, up from 900k in Q1 2009, and 271 million photos posted on the sites. 

A recent initiative which has significant promise is the launch of Youth Sports Share Sites.  This provides an integrated tool and website to coordinate team logistics, calendars, team rosters, communicate updates and create a platform to post photos and videos, and drive sales of photo books.  To do this, SFLY has partnered with national and regional Youth Soccer, football and cheerleading organizations; and during Q3 more than 15,000 youth sport sites were created.  To put this low cost form of customer acquisition in perspective - of the 15k sites created, assume there are 30 people per team - from this quarters additions, 450k users are now registered and attached to Shutterfly.  Assume that 10% of those users actually purchase a photo book of their team - a conservative estimate - that's 45k transacting customers purchasing a product with an AOV north of the $32 company average.  During Q3, the company had 982k transacting customers.  As they focus their marketing message to schools next, and continue focusing on teams and families, there is potential to accelerate growth for the PP&S segment and lower SAC. 

In addition, advertising remains an untapped revenue opportunity for SFLY.  The populations that Share Sites are aggregating are extremely targetable and valuable demographics to brand advertisers.  Currently, the scale is not there to make this an important revenue driver, but as Share Site adoption continues, management believes this could be north of a $15 million revenue opportunity, with EBITDA margins significantly higher than 18%.   Currently, the company is getting $3-$4 CPMs, with the target audience being mothers and families.  This is an area to continue to watch gain scale in the future.

SFLY has partnered with Motionbox to experiment in the video sharing business.  At this point, this is neither a generator of revenue, nor a driver of expenses or capital as Motionbox is footing the bill.  However, this allows SFLY to test business models around video sharing.  This is the most requested product by SFLY customers, so despite not having a strong business plan at this point, it is satisfying the demand by customers, and adding to the customer satisfaction.  In the next few quarters, we expect to hear more from SLFY regarding their video initiatives. 

Margin Discussion

The company has had healthy margins historically, gross margins around 55%, and EBITDA margins in the 17-18% range.  The driver of margins going forward will be dictated for the most part by product mix.  Personalized Products & Services (PP&S) has a higher margin profile than prints do.  With PP&S revs now at 58% of the total, prints at 39% and commercial at 3%, margins should trend higher as the growth in PP&S at 22% continues to change the mix shift from prints.  While prints have actually been increasing in volume every quarter, a price reduction in late 2008 has made for difficult comps for the print business this year.  In Q3, print revenue was down 6%.  Q4 should be the first quarter with favorable comps as pricing has remained relatively stable for prints since the late Q3 2008 price cut. 

Gross margins in 2009 have been depressed to around 53% due to the process of relocating one of its two production facilities from California to Phoenix, AZ.  They finished moving 100% of the production during Q3.  The new facility offers labor costs that are 30% lower than the old facility, and power costs that are 60% lower.  This should benefit the photo book product line disproportionately as it is highly labor intensive (1/3 of direct costs are labor).  The building lease cost is actually higher, but net net Gross Margins should see a nice recovery into Q4 and next year.  Embedded in the 2009 margins are also roughly $3 million of one time costs related to the startup of the new facility which will not be seen in 2010.  We estimate that due to product mix shifts, the new facility and elimination of one-time costs, gross margins should increase by 200 bps in 2010. 

Future margin leverage will come from a few line items.  Sales and Marketing costs at 17.4% of revenues now, should continue to decline as a % of revenues as Subscriber Acquisition Cost (SAC) declines due to scaling of shared sites, new partnerships with sports teams, youth organizations and schools, use of social media and new direct to consumer programs.  Grass roots efforts for adoption of shared sites include partnerships with Youth Sports leagues driving further penetration and reliance on the team shared site, house parties where friends and family create Simple Path photo books and receive a free 7x9 photo book and in-mall Photography teach-in programs.  The company's presence on Facebook and Twitter is new and growing. In Q3, SFLY made a $2 mm acquisition of Tiny Pictures, a company that develops applications for sharing videos and pictures across social networks and mobile platforms.  This acquisition should help to accelerate integration with social networking mediums.  They also recently launched a new blog called Picture More offering tips and tools on photography, photo book making etc.  In addition, investments in the marketing team, including a hire from eBay focused on online marketing analytics should provide more efficient online marketing spend. 

Technology and Development investment has been robust at almost 19% of revenues in 2009.  Continued R&D investment is core to the business and for differentiating from the competition, but there will be scale over the next few years in site operations including hardware, collocation, and bandwidth.  They are currently studying the feasibility of building their own data center to accommodate the growing number of servers, which aside from adding NT capex will reduce operating costs in the long term.  2010 should see a reduction from 2009 levels as some of the costs related to a site redesign the Phoenix facility launch

While EBITDA margins should finish the year around 18%, in the LT they should gravitate to 25+%.  Capex requirements should grow slower than revenues, as infrastructure and server costs drop disproportionately driving free cash flow.

Competitive Landscape

In July, Kodak implemented a new policy requiring anybody using photo storage to make an annual purchase or risk losing their pictures.  This policy, wasn't taken well by the Kodak user base, and was picked up in the media.  This provided an opportunity for SFLY to poach Kodak Gallery users.  The Kodak customer base has historically been significantly less active than SFLY.  They claim to have north of 25 million subscribers' vs. the ~6 million that SFLY has, yet they also generate less than ½ the revenue of Shutterfly.  SFLY marketed heavily to the Kodak customer base in response, offering aggressive promotions and uploads to the site if you mail in your CD of pictures.  On the Q2 call, management discussed that anecdotally they were taking customers and gaining market share.  Order volumes saw a 7% increase in Q2 y/y vs. a decline in volumes in Q1 of 9%.  Management has confidence, based on prior photo gallery shutdowns by Sony and Yahoo, that customers that have historically had lower AOVs will be up sold over time to resemble the traditional SFLY user.  SFLY has no intention to ever charge for storage. 

Kodak recently re-launched its website and lowered their pricing on 4x6 prints from $0.15 to $0.09.  While the pricing change scared the street and triggered a selloff in SFLY shares, we do not believe this will have any significant impact on the business.  4x6 prints now account for only 24% of revenues, down from 29% in Q3 2008.  On top of this, Snapfish lowered their pricing to $0.09 in 2008, while Kodak and SFLY stayed at the $0.15 level.  The change by Snapfish had no impact on the 4x6 business, and in fact despite not being the low cost provider, 4x6 prints have continued to show single digit volume growth.  On top of this, due to promotions and prepaid offers, the blended price per print for SFLY is actually closer to $0.12, also the industry average. 

Another competitive offering that spooked the market has been a more focused attempt by Vistaprint (VPRT) to enter the consumer market.  Thus far, the photo book products they have launched are not competitive in this market.  The site does not offer online photo storage, and the turnaround time for a photo book exceeds 2 weeks.  The offering has been available for over 2 years now, but is now being re-launched with more options.  These products are lower end, lower priced and we expect will compete more effectively with Snapfish and other low priced providers.  VPRT has done a tremendous job marketing to the SMB space, however we believe that entering the higher end consumer market is not their core marketing competency.  We do not expect VPRT to gain any significant amount of market share in the near term.

There are significant barriers to entry in this market.  This is inherently a scale business, and SFLY is the only operator which is profitable on a cash flow basis.  SFLY has two in-house production facilities, the only company in the industry which produces all of its products (Kodak and Snapfish outsource production).  Continued innovation is key to success in this business to keep a differentiated product requiring continued R&D investment.  On top of that, SFLY has a significant customer base with brand loyalty in what is typically a sticky business with relatively large switching costs to move your pictures from one provider to the next. 

Lead Generation Short Thesis

There has been a short thesis on SFLY making its way around Wall Street based upon revenues generated from a referral fee arrangement with WebLoyalty, an online lead generation company.  On certain completed transactions, an offer from Webloyalty will be presented to the customer offering some type of customer reward in return for signing up for some external service.  These practices have come into question with e-commerce companies before - notably VPRT which at one point had north of 20% of revenues coming from this type of source.  Since this program began in Q4 2006, total referral fees have been roughly 3% of revenue.  This year, they will make up 2.5% of net revenues declining to 2% in 2010.  While this is not a high quality business, the company is scaling it down to 0 in the next few years.  It is a generator of high margin cash flow but is not driving the growth or margin profile of the business, and has never had an important role within the financials.  Currently Congress has subpoenaed 19 companies, including Continental Airlines, PCLN, VPRT among others in an attempt to learn more about this business practice.  A worst case scenario if this revenue were to completely disappear immediately would trigger a loss of 2-2.5% in revenues or $6 million and $4-5 in EBITDA. We do not expect this to occur.  Congress may require more stringent 'opt-ins' or consumer disclosure.  As it is decreasing as a % of revenue, and given the limited scale of this, we believe a viable short thesis around this low quality revenue is completely unwarranted. 

Catalysts

VPRT trades at a significant discount to the ecommerce universe.  Currently, it is trading at 5.4x 2010 EV/EBITDA, compared to the comp universe at 14x.  We believe that the discount is unwarranted, and that several near term catalysts will help close the valuation gap.  First, with conservative guidance offered to the street, expectations for a solid Q4 despite how positive operating trends have been YTD remain muted.  With the significant increase in consumer confidence relative to Q4 2008, easy comps and a significantly more competitive offering in the market, Q4 should shape up to be a solid quarter.  Operating trends through October have maintained the momentum from Q3.  30% of revenues are generated between Thanksgiving and New Years.  Assuming even a modest economic recovery in 2010, revenue growth opportunities being focused on by the company should gain traction.  These include continued mix shift to higher AOV photo books driven by Simple Path, continued scaling of the Commercial Printing initiative with high revenue flow through, further adoption of Share Sites by families and partnerships with youth sports leagues and schools and growth from Designer Stationary. 

On top of that, margin expansion of 200 bps should be generated from various sources: Operating margin improvement due to labor and power savings at the Phoenix operating facility; a lack of one-time Phoenix start-up costs; SAC improvements driven by the continued success of Share Sites; higher margin products such as photo books and stationary growing at faster rates than prints; and advertising revenue growth from almost 0 today.

Rumors have circulated for awhile, that Kodak was looking to sell Kodak Gallery.  Shutterfly has commented on its desire to own the asset and consolidate the industry.  We believe this would offer not only scale benefits but a significantly improved competitive landscape.  SFLY has also discussed other uses of its cash including looking to purchase differentiated products or invest in businesses to increase advertising revenue.  Lastly, while not expected in the near term, SFLY would make an attractive take-out candidate by VPRT, as their initiative into the consumer market has thus far not gotten them very far. 

Trading at only 5.4x, with Revenue, EBITDA and FCF growth expected to significantly ramp over the next year, we believe that the market is significantly discounting the differentiation and market leadership SFLY exhibits in the photo market.  Discounting, promotions and new competitors are not new in this market, and have not been effective in eroding SFLY's market share - nor do we believe given the initiatives discussed above that they will.  With the stock price trading over 50% below its 2007 highs, and at ridiculously cheap multiples, we believe there is upside north of 50% in the next year as growth accelerates and the company closes the multiple gap between other industry participants.  At 8x 2011 EBITDA, still a discount to the ecommerce landscape, shares would be north of $24 / share.  This case assumes a modest consumer economic recovery and continued strong execution in 2010.  Assuming a continued weak operating environment, with 2010 growth at 6%, our target remains well over 30% above the current trading range at $20, with a 7x multiple of 2011 EBITDA.

Risks

- Consumer spending does not return over the next 18 months, muting industry growth

- Losing roughly $6 million of revenues and $4-$5 million of gross profits to shutdown of lead generation business

- Eventual pricing competition at the higher end of photo books prior to mass adoption; - - Dilutive or misunderstood acquisition away from the core business

- $52 mm of auction rate securities - are accruing interest and are fully redeemable by UBS in June 2010

- Consolidation in the industry they are not involved in

- Lack of interest in new product launches including failure to scale commercial printing

Catalyst

- Conservative guidance despite expected strong Q4; street estimates rising

- Unwinding of discounted valuation due to Q4 seasonality and consumer spending uncertainty 

- Margin expansion of 200 bps into 2010 caused by new operating facility, SAC improvements, Share Sites, higher margin products

- Kodak Gallery sale?

- End of Lead Generation overhang