Description

Help Wanted: Activist Needed!

Business Description and Background: 

Shutterfly is an exceptional business trading at an attractive valuation with a management team that has demonstrated strong operational performance. However, the Company, which operates out of Silicon Valley, views its peers as Google, Facebook and Amazon and, as a result, has been an underwhelming capital allocator and a heavy user of stock-based compensation. In addition, similar to AMZN, SFLY uses it income statement to incubate pet projects with uncertain future economics.  SFLY would benefit immensely from some general “tough love” and guidance.

We see ($27)mm of EBITDA losses this year coming from various “growth” projects including Treat and ThisLife, which mask the profitability of the “core” business. We think SFLY trades at 6.1x 2015E “core” EBITDA and a ~9% “core” unlevered free cash flow yield - a very attractive valuation for a company growing revenues in the low-to-mid double digits organically. We see over 50% near-term upside in the stock (price target ~$64) with relatively modest downside (~$35.50 or ~16% downside), incremental upside if management adopts a more shareholder-friendly mentality (~$69.00 or 64% upside), and further upside if some investment spend converts to value (~$79.00 or 88% upside) . 

We think many prospective investors perceive SFLY as merely a printer of 4x6 pictures that is therefore secularly challenged. We disagree. SFLY is actually enjoying secular tailwinds and is wrapping up a major investment cycle this year. SFLY organic growth has been in the low-to-mid teens and we think double-digit organic growth is sustainable for at least several more years; and prior growth spend will begin to be harvested. As we explain below, the stock at current levels presents a compelling risk/reward.

Shutterfly Inc. (SFLY) is the “leading manufacturer and digital retailer of high-quality personalized products and services” in the US.   SFLY’s flagship brand is Shutterfly.com which accounts for the lion’s share of revenue, but the company operates six other premium lifestyle brands including TinyPrints (cards and stationary boutique), Wedding Paper Divas (personalized wedding invitations), Treat (greeting cards), ThisLife (digital photo management), MyPublisher (customized photobooks) and BorrowLenses (high-end photo/video equipment rental).  SFLY operates two businesses: “personalized products” and “memory preservation”.  

Personalized products - SFLY sells scores of different high-quality personalized products including photobooks, cards, invitations, home décor, etc. (4x6 prints are only ~4% of revenues).  SFLY’s bread-and-butter customer is a relatively affluent mother.  Infotrends estimates the US “personal publishing addressable market” (stationary, calendars, photo gifts, prints, photobooks and greeting cards) alone is ~$32 billion and online penetration overall (i.e. what SFLY actually does) is believed to be somewhere in the neighborhood of ~10% penetrated (varies by vertical).  Shutterfly.com alone is roughly 6.5-7.0x the size of its closest US competitor Snapfish, and that gap keeps widening as Shutterfly continues to take share.  Our understanding is Snapfish (a non-core asset of HPQ) is a $200-$300mm business: half branded (like Shutterfly) and half white (private) label, with low or negative consolidated EBITDA margins.

SFLY is a very seasonal business but has recently started to attain critical mass in the enterprise printing business. While there is nothing particularly special about the lower-margin enterprise business, we think it’s a decent way to soak up excess seasonal capacity.  SFLY is currently a Q4 business, but we think that extreme seasonality will diminish somewhat over time.  SFLY’s recent addition of GrooveBook, a subscription photobook business, should also assist in reducing seasonality. 

Memory preservation - ThisLife is a relatively seamless way of gathering and organizing your photos and videos no matter where they’re stored (Mac, Windows, Facebook, iPhone, Android, etc.).   We suggest watching the video on ThisLife.com to better understand how it’s positioned (https://www.thislife.com/?cid=CB-TL-SEM-TL-GOOGLE-BRAND&mpch=ads). 

ThisLife was soft-launched in Q3 with only ~$1mm of “test” marketing put into it so far. We think ThisLife is about 30% complete in terms of its eventual functionality; by next holiday season, ThisLife should be substantially complete.  SFLY has been exploring the concept of charging customers for storing photos on ThisLife.  We actually think SFLY should (and will) just give away unlimited photo storage for free (like Amazon Prime recently announced) for added customer stickiness, with monetization to come by way of seamlessly integrating photos with personalized product creation.  

By the end of 2014, we estimate SFLY will have plowed $50mm-$100mm of cumulative invested capital into ThisLife (between the acquisition price, opex and capex). We think the street is implicitly giving SFLY negative credit for ThisLife by capitalizing losses into perpetuity.  ThisLife clearly has some amount of value (i.e. driving incremental orders), but we ascribe essentially zero value in our base case analysis.  There is an upside case that could value this investment at greater than $10/share.

Investment cycle: Over the past two years, SFLY has undergone an aggressive investment cycle (in terms of both opex and capex) that will come to an end by the end of 2014.  This investment cycle has masked the underlying profitability of the business. Notable components include heavy development spending on ThisLife, the opening of a major new facility in Shakopee, MN and duplicate data center costs related to a data center move that should generate meaningful electricity savings prospectively.  ThisLife, we estimate, should go from losing over ($10)mm in 2014 to some lesser amount of losses in 2015 (followed by breakeven-to-positive EBITDA in 2016).  The Shakopee facility startup/underutilization costs (we estimate ~($4)mm) incurred in 2014 will disappear in 2015.  According to management guidance, SFLY will burn ($8)-($6)mm in 2014 on “duplicative data center costs” that will go away in 2015.  The purpose of incurring duplicative data center costs in 2014 is to facilitate $35 mm of run-rate electricity cost savings by 2017.  Apparently, those electricity savings are back-end loaded, so we assume a $5mm yoy benefit in 2015 followed by another $10 mm incremental benefit in 2016.  Treat EBITDA is negative ($5) mm annually – we assume that burn continues in 2015, but gets to either break-even or is shut-down in 2016.  The enterprise business is relatively low-margin given where it’s starting – we assume 12% EBITDA margins in 2014 implying ~$6 mm of enterprise EBITDA in 2014.  Backing out the components listed above, we think “core” consumer EBITDA is running at ~$196 mm (22.5% margins, which we believe is not inconsistent with prior management commentary).  Lastly, capex is guided to ramp back down to more normalized levels in 2015.

EBITDA Bridges:

As we think about forecasting 2015+2016, we “start” from theoretical 2014E “core” Adj. EBITDA of $202mm ($6 enterprise+$196 consumer). We assume consumer revenues (which has nothing from ThisLife embedded) continue to grow at ~13% organically for the next two years with an average incremental EBITDA margin of 35% (adding $40mm in yoy core EBITDA in ‘15E and $45mm yoy in ’16E).  We assume the enterprise business’ momentum continues for the next two years, ramping from $50mm in ‘14E to $75mm in ‘15E to $100mm in ‘16E at an incremental margin of only 25% (adding $6mm in yoy core EBITDA in ‘15E and $6mm in ’16E).  We layer in $5mm of electricity cost save tailwinds in ‘15E, plus an incremental $10mm in savings in ‘16E. This bridging exercise results in “core” EBITDA of $202mm in ‘14E, $253mm in ‘15E and $314mm in ’16E.

“Other” (i.e. ex-core) EBITDA in 2014E should shakeout to (~$27)mm, including ($11)mm of expected ThisLife losses, ($7)mm of duplicative electricity costs that will disappear, ($5)mm of Treat losses and ($4)mm of estimated start-up costs at Shakopee. Moving from ‘14E to ‘15E, we forecast $6mm of tailwinds from ThisLife losing less money, $7mm for the lapping of duplicative electricity costs and $4mm for the lapping of startup losses at Shakopee.  Rolling forward from ‘15E to ‘16E, we expect “other” EBITDA to pick-up an incremental $5mm from ThisLife moving to break-even (or shut-down) and $5mm from Treat either hitting breakeven or being shut-down. It’s incredibly important to stress that our 2016E forecasts merely assume ThisLife stops losing money (worst case it’s shut down completely), and our thesis regards ThisLife as upside optionality. The upshot is “other” EBITDA of ($27)mm in ‘14E, ($10)mm in ‘15E and $0 in ’16E.

Adding “core” plus “other” EBITDA results in combined EBITDA of $175mm, $243mm and $314mm (for ‘14E through ‘16E) vs. street at $169mm, $208mm and $245mm respectively.

Valuation:

SFLY’s Q3 2014 balance sheet reflects net cash of roughly zero, and we expect at least ~$200 mm of free cash will come in the door in Q4 2014E (we model ~$216mm) resulting in projected 2014 year-end net cash of ~$217mm (~$5.00 per share assuming ~42.6 mm fully-diluted shares). 

At a recent quote of $42.01, SFLY was trading at ~6.1x 2015 “core” EBITDA, implying a ~9.1% fully-taxed unlevered free cash flow yield. That amounts to ~4.6x 2016 “core” EBITDA, implying a 12.1% fully-taxed unlevered free cash flow yield.

Given SFLY’s organic growth prospects and dominant market position, we value SFLY at 10x core EBITDA plus forward net cash, implying a 5.5% fully-taxed unlevered free cash flow yield on 2015 estimates. 10x core 2015 EBITDA plus cash implies a ~$64 stock price.   Applying an 8x core 2015 EBITDA multiple would imply a ~6.9% fully-taxed unlevered free cash flow yield and a ~$54 stock price.

Running the same 10x exercise on 2016 “core” EBITDA implies an ~5.6% fully-taxed unlevered free cash flow yield resulting in an ~$78 stock in one year’s time (~$71 discounted back to today at 10%) .

We think a reasonable illustrative downside case would be ~6x 2015E street EBITDA of $207mm resulting in a ~$35.50 stock price (implying an ~8.9% fully-taxed unlevered free cash flow to the firm).

Free Cash Flow Deployment: Our valuation scenarios above imply cash just builds up on the balance sheet for the next two years.  We think the company can create incremental value by buying back a meaningful amount of stock, particularly given the gap between intrinsic value and the current trading price. 

Also, the company has been extremely disciplined about acquisitions, but management could create significant value if they’re able to find an asset at a reasonable valuation and plug it into their platform. Below is the theoretical valuation impact of buying a theoretical target with a similar growth profile at 5x synergized-EBITDA:

Sale Process: On 7/2/14, Bloomberg reported that SFLY hired Qatalyst as part of a sale process, which turned SFLY into a “deal stock” for several months.  On 10/10/14, Bloomberg reported “Silver Lake Management LLC has shelved an attempt to acquire and combine photo-sharing sites Shutterfly Inc and Snapfish”.  That same article said “Silver Lake was valuing Shutterfly at about 12 times its future earnings before interest, taxes, depreciation and amortization, another person said. That implies a purchase price of about $2.57 bn, based on estimates for 2015 Ebitda of $214 million, according to data compiled by Bloomberg.”  When SFLY reported results on 10/29/14, SFLY admitted that it had been in discussions to sell the company.  On the earnings call, SFLY’s CEO explicitly stated: “During the quarter, we received bids by several outside parties to acquire the company”.  Management argued that the value of executing on their five-year plan exceeded the value of the acquisition offers they received.  If our thesis is generally correct, we don’t see why SFLY couldn’t receive a better offer(s) in a year or two as the true earnings power of the business becomes more apparent.  In the interim, we believe SFLY remains for sale to anyone willing to put forward an offer that reflects the appropriate intrinsic value of the business.  We think private equity bids must have contemplated using 5x-6x leverage – yet, inexplicably, SFLY is operating with a net cash balance.

Criticism: There is apparently a lazy short thesis that SFLY is discounting aggressively because growth is slowing, hence gross margin degradation. We don’t think that’s right.  Management has been taking up base pricing across the board while offering the same level of headline discount as in the prior year, resulting in higher net pricing (which manifests in higher average order values).  Gross margins have recently been impacted by additional depreciation expense and a mix shift where Shutterfly.com has grown faster than the higher-margin TinyPrints business. 

There is some legitimate criticism with which we do agree. First, while we think the CEO is a very good operator, there’s clearly meaningful “room for improvement” on the way he thinks about share repurchases. We also take issue with what we think is an overly generous stock-based compensation philosophy.  The company is paying employees in part by issuing undervalued, restricted stock which their employees, we suspect, mentally value at significantly less than the same headline amount paid in cash.  In other words, we think the ~$60mm of stock-based comp they’ll expense this year could have been a fraction of that if it was simply paid in cash (sparing the associated dilution).  In addition, we think the company needs to do a better job communicating with the street and explaining and disclosing the various moving pieces within their business. We’re optimistic the company will eventually address these issues, though it’ll likely take a lot longer than we’d like.

Apparently, we are not the only shareholders with certain grievances. SFLY has struggled somewhat to get its executive compensation program approved by shareholders in recent years.  At the most recent annual meeting 17.3mm shares voted “AGAINST” the “approval, on an advisory basis, of the Compensation of our Named Executive Officers” (17.4mm shares voted “FOR”, 0.2mm shares “ABSTAINED” and 3.2mm were “BROKER NON-VOTES).  While many investors tend to ignore this vote as its non-binding, we actually think the messaging is important and has consequently been a huge embarrassment for management.  At the same meeting, director Ann Mather resigned because she “did not receive the votes required to be elected as a director” (nevertheless, the board invited her right back on).  In addition, Marathon Partners Equity Management has an outstanding 13D, and recently sent a letter to the board of directors on 11/4/14.  Lastly, proxy season is rapidly approaching.

Key Risks:

*Consumer growth could slow sooner than it should

*Enterprise momentum could stall

*ThisLife could be an abject failure; but even if that happened, it’d get shut down and its current drag on EBITDA would go away

*Management could choose not to “show” enough of the true earnings power of the business next year (e.g. ramping marketing spending and thereby masking core EBITDA margins)

*Management could do a dumb acquisition in theory, but they’ve actually been extremely disciplined on M&A historically

Catalyst

*Earnings (in particular Q4) and 2015E guidance

*”Full” launch of ThisLife in 2H 2015

*Possible shareholder activism if the stock price languishes

*Possible sale of the business at some future date