Shutterfly (NASDAQ:SFLY) reported another year of double-digit growth in revenues to reach $784 million. However, both revenues and gross margins were negatively impacted by a production issue with the company’s Tiny Prints brand. For fiscal 2013, adjusted gross margins, which excludes the share-based expense component from cost of revenues, contracted to 53.2% from 54.2% in 2012. Additionally, operating profit margin decreased from 6.4% in 2012 to 2.8% in 2013 due to higher operating expenses.
Net income for the company reduced to $9.3 million from $23 million in 2012, due to a significant increase in interest expense. Shutterfly’s interest coverage ratio nose-dived from 68.2 to 2.3 in 2013, due to the issue of the $220 million Convertible Senior Notes during Q2FY13.  In this earnings note, we highlight key takeaways from Shutterfly’s Q4 earnings that have material impact of the stock’s price going forward.
Inorganic Channels Lend Support To Customer Order Growth
The number of orders processed by Shutterfly in fiscal 2013 grew 13.7% to reach 18.6 million. In Q4 alone, orders grew 12% on a year-on-year basis to reach 7.7 million. In addition to strong growth in orders, Shutterfly’s average order value (AOV) expanded sharply during Q4, from $49.80 to an all-time high of $51.80.  This expansion in AOV during its peak season sales in Q4 helped in the expansion of AOV for the entire fiscal 2013 by approximately 7% to $40.19. Much of this expansion in AOV is a result of new premium offerings during the holiday season across its Tiny Prints and Shutterfly brands.
However, growth in the total number of customers Shutterfly catered to during the fiscal outpaced order growth, at 14.6%. This faster growth in customer base compared to orders led to a reduction in the company’s average orders per customer in fiscal 2013. The decrease in average orders per customer is a result of Shutterfly’s acquisitions such as R and R Images and Borrow Lenses in 2013. We believe that the average order per customer for these acquisitions was lower than the metric for Shutterfly’s core business, leading to a decline. However, this metric should begin to increase going forward as Shutterfly leverages its brand portfolio and creates various cross-selling channels through these acquisitions. These cross-selling activities should lead to further expansion in the company’s AOV. Additionally, good cross-selling activities should improve customer retention and increase overall customer base in the long term.
Margin Contraction To Continue As Shutterfly Focuses On Building Scale
Shutterfly’s margin contraction in 2013 was a result of an increase in cost of revenues and operating expenses relating to its new manufacturing facility in Fort Mill, South Carolina during the fiscal. This new manufacturing facility triples Shutterfly’s geographic footprint in the Southeast and should result in a higher revenues and lower time-to-market for its products in the long term.  Additionally, Shutterfly continued the build-out of a new manufacturing facility in Shakopee, Minnesota And it planned the consolidation of its operations in its Arizona facility into a single unit for 2014.  These expansionary plans should continue to weigh on Shutterfly’s margins in the short term. However, margins should see strong upside once these facilities are completed and augmenting revenue.
Lending support to a short term contraction in margins is the company’s Enterprise division. Although the company doesn’t provide details on individual margin performance, management states that margins for the Enterprise division have a negative impact on overall company margins.  Going forward, we expect strong growth for Shutterfly’s commercial printing business, which should continue to have a negative impact on overall margins. However, this negative effect of Enterprise business on margins should be offset by the margin expansion achieved through operational scaling in the long term.
We have a revised price estimate of $49 for Shutterfly to reflect its latest Q4FY13 earnings.Notes:
- Shutterfly, Inc. Proposed Offering of $220 Million Convertible Senior Notes, Shutterfly IR, May 2013 [↩]
- Shutterfly Management Discusses Q4 2013 Results – Earnings Call Transcript, Seeking Alpha, February 2014 [↩] [↩] [↩]
- Shutterfly Management Discusses Q2 2013 Results – Earnings Call Transcript, Seeking Alpha, February 2014 [↩]