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September 17, 2006

Will The ShutterFly IPO Fly?

posted by MR WAVETHEORY at 9/17/2006 10:34:00 PM
ShutterFly, Inc.'s pending IPO proves that dot-com IPOs are back. ShutterFly enables consumers to upload, share, and print & print photos online. ShutterFly, Inc. is trying to sell 5.8 million shares at between $13-15 per share in an IPO worth roughly $73 million. With the excitement over photo sharing and the growing popularity of services like FlickR, I took alook at the ShutterFly prospectus to see for myself whether to snap up some shares on the IPO.

Market Opportunity

ShutterFly is going after a very broad market opportunity.
We are an Internet-based social expression and personal publishing service that enables consumers to share, print and preserve their memories by leveraging our technology, manufacturing, web-design and merchandising capabilities. Our vision is to make the world a better place by helping people share life’s joy. Our mission is to build an unrivaled service that enables deeper, more personal relationships between our customers and those who matter most in their lives. Today, with the evolution of digital cameras and technology, millions of people around the world are capturing their memories and communicating in more meaningful ways. We provide a wide range of products and services that allow consumers to upload, edit, enhance, organize, find, share, create, print and preserve their digital photos.
What I like about the photo sharing market is that it takes an existing business that used to be offline and transplants the entire industry online. The company's market is very large and that is why the company has shown some great numbers.
We have experienced rapid growth since launching our service in December 1999. Since inception, we have fulfilled more than 12 million orders, sold approximately 370 million prints and stored approximately one billion of our consumers’ photos in our image archives.
Business ModelBroadly speaking, ShutterFly is an online photo print business. ShutterFly believes that the market will grow from $424 million in 2005 to $1.9 billion in 2009. This implies a compounded annual growth rate of 45% per year! That is very impressive. But is this a good deal? ShutterFly cities a viral network effect as one of the keystones of its business. I think this is hogwash. People share photos, but the growth of ShutterFly is hardly exponential. I do concede that they have a very attractive customer demographic.
Based on our periodic customer surveys, we believe that our current customer base fits the following profile: approximately 84% female, approximately 63% in the 25-44 age range and approximately 53% with children. Our surveys also indicate that the average household income of our customers is greater than $75,000.
Females tend to do most of the shopping and 84% female is a great skew in demographic. It is also a slighly older crowd which means disposable income to spend.

Growth Has Been Consistent But Is Slowing

ShutterFly grew revenues from $31 million to $54 million to $84 million in 2003, 2004, and 2005 or roughly 74% between 2003 and 2004, and 55% between 2004 and 2005. Profits grew from $2.1 million to $3.9 million to $4.4 million in 2005 or 85% and 12% sequentially - indicating profits haven't been growing as fast as revenues. This implies declining margins. The slowing sequential growth rate is alarming, because it demonstrates that the market is maturing. Judging from ShutterFly's estimate of market size, it owns $84 million of a $424 million market (20%). It will probably be hard to grow at an able market rate.

ShutterFly may own such a big piece of the online printing market that it may have grown slower than the market. According to the S-1, the company grew revenues from $27.7 million in the first half of 2005 to $36.5 million in the first half of 2006. That is a growth rate of only 31%. When the market is estimated to grow at 45% and ShutterFly is growing at 31%, that is a cause for concern.

Growth Has Not Been Cheap

In order to achieve its revenue growth, ShutterFly has had to double sales and marketing spend every year from 2003 to 2005 from $3.9, $7.7, to $15.2 million. Part of the reason that growth has not been forthcoming in 2006 is that sales and marketing spend only increased by 58% from $5.1 million to $8.1 million. There is no doubt, that if marketing spend had doubled, then it would have lost even more money.

Capital Expenditure Plan Is a Concern

One particular item to note is that this business seems to require a lot of capital expenditure.
We expect to have ongoing capital expenditure requirements to support our growing website infrastructure and to meet production and manufacturing requirements. We expect capital expenditures to be between $30 million and $35 million in the second half of 2006 and through 2007.
Growth is great, but $35 million is not a small number considering that it generated $36 million in revenues in the first six months of 2006. It does bring into question the scaleability of the ShutterFly model. After all, the best type of business to invest in is one that costs less to run after adding additional customers - not more! ShutterFly doesn't seem to have economies of scale.

Business is Highly Seasonal

The biggest concern with ShutterFly is that it is a highly seasonal business. Q4 is the make or break quarter.
We generated approximately 49% of our net revenues for 2005 in the fourth quarter of 2005, and the net income that we generated during the fourth quarter of 2005 was necessary for us to achieve profitability on an annual basis for 2005. In addition, we incur significant additional expenses in the period leading up to the fourth quarter holiday season in anticipation of higher sales volume in that period, including expenses related to the hiring and training of temporary workers to meet our seasonal needs, additional inventory and equipment purchases and increased advertising. If we are unable to accurately forecast and respond to consumer demand for our products during the fourth quarter, our reputation and brand will suffer and the market price of our common stock would likely decline.
It also means that it must hire lots of temporary workers.
A majority of our workforce during the fourth quarter of 2005 was seasonal personnel hired on a temporary basis. We have had difficulties in the past with finding a sufficient number of qualified seasonal employees.
Don't Forget There is Pricing Pressure

If there is one reason not to invest, it is that this business is undergoing significant pricing pressures. Its biggest competitor cut prices by over 50% recently!
In the second quarter of 2005, certain of our competitors reduced the list prices of their 4×6 prints from $0.29 to $0.12. In response, we lowered the list price of our 4×6 prints to $0.19 in order to remain competitive. A drop in our 4×6 prices without a corresponding increase in volume would negatively impact our net revenues. Our larger competitors could elect to further reduce the list prices of their 4×6 prints or use lower pricing of prints as a loss leader. If this were to occur, we might not be able to
remain competitive on pricing for 4×6 prints, which could result in a loss of customers.
ShutterFly's biggest competitors are Kodak (Ofoto) and SnapFish (HP) so the game of lowering prices could go on for a long time. A quick check shows that ShutterFly has recently lowered the 4x6 to as low as 12 cents!

It's a Shipping Company - Not a Photo Printing Business!?

As if pricing pressure were not enough, a quarter of ShutterFly's revenue come from shipping.
We generate a significant portion of our net revenues from the fees we collect from shipping our products. For example, these fees represented approximately 19% of our net revenues in 2005 and approximately 22% of our net revenues in the first six months of 2006.

ShutterFly will have 23.6 million shares outstanding after the offering. At a price of $13-15 per share, the market cap will be $306 to $354 million or roughly 3.6x to 4.2x sales in 2005. I won't speculate on revenues in 2006 or even the earnings. The company earned $28.4 million in 2005 (but that included a $24 million benefit for tax provision). Assuming $4.4 million of normalized earnings in 2005 (backing out the $24 million), the trailing P/E is 69 - 80 times trailing. Very expensive!


Given the pricing dynamics and commoditization of this market, the huge seasonality, the slowing growth of the business, and the lack of profitability, ShutterFly is vertically challenged. I am sorry to say that the ShutterFly IPO will not fly.

Update Link: ShutterFly RoadShow Presentation

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Blogger Mark said...

Do you mean that it won't fly long term, or that the IPO wouldn't take like it did?

I thought this was an odd IPO to do as well as it did, for all the reasons you cited. They do have a recognized brand, so maybe they think they can capitalize on that over the long term and fight off the competitors.

6:29 PM  

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