XNAS:SFLY Shutterfly Inc Quarterly Report 10-Q Filing - 6/30/2012

Effective Date 6/30/2012

XNAS:SFLY (Shutterfly Inc): Fair Value Estimate
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XNAS:SFLY (Shutterfly Inc): Consider Buying
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XNAS:SFLY (Shutterfly Inc): Fair Value Uncertainty
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UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, DC 20549

Form 10-Q
 
(Mark One)
x
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended June 30, 2012
 
or
o
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from            to
 
Commission file number 001-33031

SHUTTERFLY, INC.
(Exact Name of Registrant as Specified in Its Charter)

Delaware
 
94-3330068
( State or Other Jurisdiction of Incorporation or Organization)
 
(IRS Employer Identification No.)

2800 Bridge Parkway
Redwood City, California
 
94065
(Address of Principal Executive Offices)
 
(Zip Code)

Registrant’s Telephone Number, Including Area Code
(650) 610-5200

Indicate by check mark whether the Registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes   x       No   o

Indicate by check mark whether the Registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T ( § 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the Registrant was required to submit and post such files).  Yes x      No o

Indicate by check mark whether the Registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company. See definition of “accelerated filer,” “large accelerated filer,” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

Large accelerated Filer   x
Accelerated Filer   o
Non-accelerated Filer   o
Smaller reporting company o
(Do not check if a smaller reporting company)

Indicate by check mark whether the Registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes   o      No   x

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.

Class
 
Outstanding at July 26, 2012
Common stock, $0.0001 par value per share
 
35,991,646
 


 
 

 
 

 
Page
Number
Part I - Financial Information
 
Item 1. Financial Statements
 
3
4
5
6
13
22
22
Part II - Other Information
 
23
24
37
37
37
37
38
39
40
EXHIBIT 3.02
 
EXHIBIT 31.01
 
EXHIBIT 32.01
 
 
 
PART IFINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS


SHUTTERFLY, INC.
(In thousands, except par value amounts)
(Unaudited)
 
 
 
June 30,
2012
 
 
December 31,
2011
 
ASSETS
 
 
 
 
 
 
Current assets:
 
 
 
 
 
 
Cash and cash equivalents
 
$
118,083
 
 
$
179,915
 
Accounts receivable, net
 
 
11,110
 
 
 
12,997
 
Inventories
 
 
3,884
 
 
 
3,726
 
Deferred tax asset, current portion
 
 
598
 
 
 
598
 
Prepaid expenses and other current assets
 
 
43,320
 
 
 
13,870
 
Total current assets
 
 
176,995
 
 
 
211,106
 
Property and equipment, net
 
 
66,361
 
 
 
54,123
 
Intangible assets, net
   
114,588
     
95,016
 
Goodwill
 
 
342,046
 
 
 
340,408
 
Deferred tax asset, net of current portion
 
 
4,075
 
 
 
3,785
 
Other assets
 
 
5,186
 
 
 
5,448
 
Total assets
 
$
709,251
 
 
$
709,886
 
LIABILITIES AND STOCKHOLDERS’ EQUITY
 
 
 
 
 
 
 
 
Current liabilities:
 
 
 
 
 
 
 
 
Accounts payable
 
$
13,356
 
 
$
9,470
 
Accrued liabilities
 
 
31,933
 
 
 
59,271
 
Deferred revenue
 
 
13,584
 
 
 
12,106
 
Total current liabilities
 
 
58,873
 
 
 
80,847
 
Deferred tax liability
   
12,403
     
13,948
 
Other liabilities
 
 
5,736
 
 
 
6,094
 
Total liabilities
 
 
77,012
 
 
 
100,889
 
Commitments and contingencies (Note 5)
 
 
 
 
 
 
 
 
Stockholders’ equity
 
 
 
 
 
 
 
 
Common stock, $0.0001 par value; 100,000 shares authorized; 35,958 and 34,839 shares
issued and outstanding on June 30, 2012 and December 31, 2011, respectively
   
4
     
4
 
Additional paid-in capital
 
 
631,859
 
 
 
589,067
 
Accumulated earnings
 
 
376
 
 
 
19,926
 
Total stockholders' equity
 
 
632,239
 
 
 
608,997
 
Total liabilities and stockholders' equity
 
$
709,251
 
 
$
709,886
 
 
The accompanying notes are an integral part of these condensed consolidated financial statements.
 

SHUTTERFLY, INC.
(In thousands, except per share amounts)
(Unaudited)

 
 
Three Months Ended
 
 
Six Months Ended
 
 
 
June 30,
 
 
June 30,
 
 
 
2012
 
 
2011
 
 
2012
 
 
2011
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Net revenues
 
$
99,020
 
 
$
75,764
 
 
$
190,311
 
 
$
132,993
 
Cost of net revenues
 
 
50,710
 
 
 
39,881
 
 
 
100,763
 
 
 
69,427
 
Gross profit
 
 
48,310
 
 
 
35,883
 
 
 
89,548
 
 
 
63,566
 
Operating expenses:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Technology and development
 
 
20,930
 
 
 
16,971
 
 
 
39,438
 
 
 
30,084
 
Sales and marketing
 
 
30,002
 
 
 
24,930
 
 
 
57,040
 
 
 
39,195
 
General and administrative
 
 
15,164
 
 
 
15,522
 
 
 
29,936
 
 
 
28,813
 
Total operating expenses
 
 
66,096
 
 
 
57,423
 
 
 
126,414
 
 
 
98,092
 
Loss from operations
 
 
(17,786
)
 
 
(21,540
)
 
 
(36,866
)
 
 
(34,526
)
Interest expense
 
 
(156
)
 
 
-
 
 
 
(308
)
 
 
-
 
Interest and other income, net
 
 
9
 
 
 
6
 
 
 
16
 
 
 
20
 
Loss before income taxes
 
 
(17,933
)
 
 
(21,534
)
 
 
(37,158
)
 
 
(34,506
)
Benefit from income taxes
 
 
8,422
 
 
 
17,884
 
 
 
17,607
 
 
 
23,096
 
Net loss
 
$
(9,511
)
 
$
(3,650
)
 
$
(19,551
)
 
$
(11,410
)
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Net loss per share - basic and diluted
 
$
(0.27
)
 
$
(0.11
)
 
$
(0.55
)
 
$
(0.37
)
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Weighted-average shares outstanding - basic and diluted
 
 
35,812
 
 
 
33,160
 
 
 
35,506
 
 
 
30,917
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Stock-based compensation is allocated as follows:
 
 
 
 
 
 
 
 
 
 
 
 
 
Cost of net revenues
 
$
443
 
 
$
754
 
 
$
905
 
 
$
929
 
Technology and development
 
 
2,675
 
 
 
2,752
 
 
 
4,963
 
 
 
3,666
 
Sales and marketing
 
 
2,745
 
 
 
4,156
 
 
 
5,895
 
 
 
5,517
 
General and administrative
 
 
3,663
 
 
 
4,437
 
 
 
7,380
 
 
 
7,222
 

The accompanying notes are an integral part of these condensed consolidated financial statements.
 
 
SHUTTERFLY, INC.
(In thousands)
(Unaudited)

 
 
Six Months Ended
June 30,
 
 
 
2012
 
 
2011
 
Cash flows from operating activities:
 
 
 
 
 
 
Net loss
 
$
(19,551
)
 
$
(11,410
)
Adjustments to reconcile net loss to net cash used in operating activities:
 
 
 
 
 
 
 
 
Depreciation and amortization
 
 
12,741
 
 
 
10,786
 
Amortization of intangible assets
 
 
9,103
 
 
 
4,206
 
Stock-based compensation, net of forfeitures
 
 
19,143
 
 
 
17,334
 
Loss/(gain) on disposal of property and equipment
 
 
(622
)
 
 
11
 
Deferred income taxes
 
 
(2,785
)
 
 
-
 
Tax benefit from stock-based compensation
 
 
16,135
 
 
 
11,585
 
Excess tax benefits from stock-based compensation
 
 
(16,135
)
 
 
(11,607
)
Changes in operating assets and liabilities:
 
 
 
 
 
 
 
 
Accounts receivable, net
 
 
1,887
 
 
 
185
 
Inventories
 
 
(159
)
 
 
1,311
 
Prepaid expenses and other current assets
 
 
(29,440
)
 
 
(38,149
)
Other assets
 
 
(211
)
 
 
(887
)
Accounts payable
 
 
2,880
 
 
 
(20,786
)
Accrued and other liabilities
 
 
(33,086
)
 
 
(20,787
)
Deferred revenue
 
 
1,478
 
 
 
194
 
Net cash used in operating activities
 
 
(38,622
)
 
 
(58,014
)
Cash flows from investing activities:
 
 
 
 
 
 
 
 
Acquisition of business and intangibles, net of cash acquired
   
(24,077
)
   
(134,036
)
Purchases of property and equipment
 
 
(17,193
)
 
 
(9,064
)
Capitalization of software and website development costs
 
 
(5,873
)
 
 
(5,044
)
Proceeds from sale of equipment
 
 
682
 
 
 
20
 
Net cash used in investing activities
 
 
(46,461
)
 
 
(148,124
)
Cash flows from financing activities:
 
 
 
 
 
 
 
 
Principal payments of capital lease obligations
 
 
-
 
 
 
(5
)
Proceeds from issuance of common stock upon exercise of stock options
 
 
7,116
 
 
 
18,227
 
Excess tax benefits from stock-based compensation
 
 
16,135
 
 
 
11,607
 
Net cash provided by financing activities
 
 
23,251
 
 
 
29,829
 
Net decrease in cash and cash equivalents
 
 
(61,832
)
 
 
(176,309
)
Cash and cash equivalents, beginning of period
 
 
179,915
 
 
 
252,244
 
Cash and cash equivalents, end of period
 
$
118,083
 
 
$
75,935
 
 
 
 
 
 
 
 
 
 
Supplemental schedule of non-cash investing activities
 
 
 
 
 
 
 
 
Net increase in accrued purchases of property and equipment
 
$
1,570
 
 
$
193
 
Amount due from adjustment of net working capital from acquired business
   
-
     
426
 
Remaining amount due for acquisition of intangible assets
 
 
4,760
 
 
 
-
 

The accompanying notes are an integral part of these condensed consolidated financial statements.
 

SHUTTERFLY, INC.

Note 1 — The Company and Summary of Significant Accounting Policies

Shutterfly, Inc. (the “Company”) was incorporated in the state of Delaware in 1999 and began its services in December 1999. The Company is an Internet-based social expression and personal publishing service that enables customers to share, print and preserve their memories by leveraging a technology-based platform and manufacturing processes. The Company provides customers a full range of products and services to organize and archive digital images; share pictures; order prints and create an assortment of personalized items such as photo books, greeting cards and stationery and calendars. The Company also provides commercial print services: printing and shipping of direct marketing and other variable data print products and formats. The Company is headquartered in Redwood City, California.

Basis of Presentation

The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America for interim financial information and, accordingly, do not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements. The accompanying unaudited condensed consolidated financial statements include the accounts of Shutterfly, Inc. and its wholly owned subsidiaries. In the opinion of management, all adjustments, consisting primarily of normal recurring accruals, considered necessary for a fair statement of the Company’s results of operations for the interim periods reported and of its financial condition as of the date of the interim balance sheet have been included. Operating results for the three and six months ended June 30, 2012 are not necessarily indicative of the results that may be expected for the year ending December 31, 2012, or for any other period.

The December 31, 2011 condensed consolidated balance sheet data was derived from audited financial statements, but does not include all disclosures required by accounting principles generally accepted in the United States of America. These unaudited interim condensed consolidated financial statements should be read in conjunction with the consolidated financial statements and related notes for the year ended December 31, 2011 included in the Company’s Annual Report on Form 10-K.

Fair Value

The Company records its financial assets and liabilities at fair value. The accounting standard for fair value provides a framework for measuring fair value, clarifies the definition of fair value, and expands disclosures regarding fair value measurements. Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability (an exit price) in an orderly transaction between market participants at the reporting date. The accounting standard establishes a three-tier hierarchy, which prioritizes the inputs used in the valuation methodologies in measuring fair value:

Level 1 – Quoted prices in active markets for identical assets or liabilities

Level 2 – Inputs other than Level 1 that are observable, either directly or indirectly, such as quoted prices for similar assets or liabilities; quoted prices in markets that are not active; or other inputs that are observable or can be corroborated by observable market data for substantially the full term of the assets or liabilities.

Level 3 – Unobservable inputs that are supported by little or no market activity and that are significant to the fair value of the assets or liabilities.

As of June 30, 2012 and December 31, 2011, the Company had cash of $59.4 million and $121.2 million, respectively, and cash equivalents of $58.7 million and $58.7 million, respectively, which are classified in the Level 1 hierarchy.

Income Taxes

The Company uses the liability method of accounting for income taxes. Under this method, deferred tax assets and liabilities are recognized by applying the statutory tax rates in effect in the years in which the differences between the financial reporting and tax filing bases of existing assets and liabilities are expected to reverse. Valuation allowances are established when necessary to reduce deferred tax assets to the amounts expected to be realized.

The Company reports a liability for unrecognized tax benefits resulting from uncertain tax positions taken or expected to be taken in a tax return. The application of income tax law is inherently complex. Laws and regulations in this area are voluminous and are often ambiguous. The Company is required to make subjective assumptions and judgments regarding its income tax exposures. Interpretations and guidance surrounding income tax laws and regulations change over time. As such, changes in the Company’s subjective assumptions and judgments can materially affect amounts recognized in the consolidated balance sheets and statements of operations.
 

SHUTTERFLY, INC.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

The Company’s policy is to recognize interest and /or penalties related to all tax positions in income tax expense.  To the extent that accrued interest and penalties do not ultimately become payable, amounts accrued will be reduced and reflected as a reduction of the overall income tax provision in the period that such determination is made.  No interest and penalties were accrued as of June 30, 2012 and December 31, 2011.

The Company is subject to taxation in Israel, the United States, California and fifteen other jurisdictions in the United States.
 
At June 30, 2012, the Company had approximately $41.1 million, $55.1 million, and $20.3 million of federal, California and other state jurisdictions net operating loss carryforwards, respectively, to reduce future taxable income, $39.5 million, $29.9 million and $20.3 million of which is associated with windfall tax benefits, respectively, that will be recorded as additional paid-in capital when realized. These carryforwards will expire beginning in the year 2028 and 2015 for federal and California purposes, respectively, and no sooner than 2022 for the portion related to 15 other state jurisdictions, if not utilized. The Company believes these deferred tax assets will be realized and as such, no valuation allowance has been set up.

Recent Accounting Pronouncements

In September 2011, the Financial Accounting Standards Board issued new accounting guidance intended to simplify goodwill impairment testing. Entities will be allowed to perform a qualitative assessment on goodwill impairment to determine whether a quantitative assessment is necessary. This guidance is effective for the Company's interim and annual periods beginning January 1, 2012. The Company does not expect the adoption of this guidance to have a material impact on the Company’s consolidated financial statements.

Note 2 — Stock-Based Compensation

Stock Option Activity

A summary of the Company’s stock option activity for the three and six months ended June 30, 2012 is as follows (share numbers and aggregate intrinsic values in thousands):
 
 
 
Number of
Options
Outstanding
 
 
Weighted
Average
Exercise
Price
 
 
Weighted
Average
Contractual
Term (Years)
 
 
Aggregate
Intrinsic
Value
 
Balances, December 31, 2011
 
 
2,768
 
 
$
 15.71
 
 
 
 
 
 
 
Granted
 
 
 43
 
 
 
27.00
 
 
 
 
 
 
 
Exercised
 
 
 (190
)
 
 
17.63
 
 
 
 
 
 
 
Forfeited, cancelled or expired
 
 
(23
)
 
 
20.38
 
 
 
 
 
 
 
Balances, March 31, 2012
 
 
 2,598
 
 
$
 15.71
 
 
 
6.1
 
 
$
 43,498
 
Granted
 
 
19
 
 
 
27.81
 
 
 
 
 
 
 
 
 
Exercised
 
 
(177
)
 
 
21.35
 
 
 
 
 
 
 
 
 
Forfeited, cancelled or expired
   
(37
)
   
24.68
                 
Balances, June 30, 2012
 
 
2,403
 
 
$
15.26
 
 
 
6.1
 
 
$
39,909
 
Options vested and expected to vest at June 30, 2012
 
 
2,320
 
 
$
14.90
 
 
 
6.0
 
 
$
39,064
 
Options vested at June 30, 2012
 
 
1,982
 
 
$
12.69
 
 
 
5.6
 
 
$
36,188
 
 
During the three months ended June 30, 2012, the Company granted options to purchase an aggregate of 19,000 shares of common stock with an estimated weighted-average grant-date fair value of $13.31 per share. The total intrinsic value of options exercised during the three months ended June 30, 2012, was $1,453,000.  Net cash proceeds from the exercise of stock options were $3,771,000 for the three months ended June 30, 2012.
 

SHUTTERFLY, INC.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

Valuation of Stock Options

The Company estimated the fair value of each option award on the date of grant using the Black-Scholes option-pricing model and the assumptions noted in the following table.  In the three and six months ended June 30, 2012 and 2011, the Company calculated volatility using an average of its historical and implied volatilities. The expected term of options gave consideration to historical exercises, post-vesting cancellations and the options’ contractual term. The risk-free rate for the expected term of the option is based on the U.S. Treasury Constant Maturity at the time of grant. The assumptions used to value options granted during the three and six months ended June 30, 2012 and 2011 were as follows:
 
 
 
Three Months Ended
June 30,
 
 
Six Months Ended
June 30,
 
 
 
2012
 
 
2011
 
 
2012
 
 
2011
 
Dividend yield
 
 
 
 
 
 
 
 
 
 
 
 
Annual risk free rate of return
 
 
0.8
%
 
 
1.9
%
 
 
0.9
%
 
 
2.1
%
Expected volatility
 
 
60.6
%
 
 
53.9
%
 
 
59.3
%
 
 
49.1
%
Expected term (years)
 
 
4.3
 
 
 
4.3
 
 
 
4.3
 
 
 
4.4
 

Employee stock-based compensation expense recognized in the three and six months ended June 30, 2012 and 2011, was calculated based on awards ultimately expected to vest and has been reduced for estimated forfeitures. Forfeitures are estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates.

Restricted Stock Units

The Company grants restricted stock units (“RSUs”) to its employees under the provisions of the 2006 Equity Incentive Plan. The cost of RSUs is determined using the fair value of the Company’s common stock on the date of grant.  RSUs typically vest and become exercisable annually, based on a three or four year total vesting term.  Compensation cost is amortized on a straight-line basis over the requisite service period.

Restricted Stock Unit Activity

A summary of the Company’s restricted stock unit activity for the three and six months ended June 30, 2012, is as follows (share numbers in thousands):
 
 
 
Number of
Units
Outstanding
   
Weighted
Average
Grant Date
Fair Value
Awarded and unvested, December 31, 2011
    1,969     $ 31.33  
Granted
    1,395       27.60  
Vested
    (609 )     21.13  
Forfeited
    (72 )     34.80  
Awarded and unvested, March 31, 2012
    2,683     $ 31.61  
Granted
    370       26.67  
Vested
    (144 )     22.06  
Forfeited
    (81 )     37.63  
Awarded and unvested, June 30, 2012
    2,828     $ 31.28  
Restricted stock units expected to vest, June 30, 2012
    2,329          
 
Included in the restricted stock unit activity above, and in connection with the acquisition of Photoccino on May 25, 2012, the Company granted 146,000 RSUs to certain employees of Photoccino. These awards vest annually over a three year period based on continued employment.
 
Also, included in the RSU grants for the six months ended June 30, 2012, are 445,000 RSUs that have both performance and service vesting criteria (“PBRSU”).  The performance criteria are tied to the Company’s 2012 financial performance and the service criteria are consistent with vesting described in the Company's 2006 Equity Incentive Plan.  Compensation cost associated with these PBRSUs is recognized on an accelerated attribution model and ultimately based on whether or not satisfaction of the performance criteria is probable.  If in the future, situations indicate that the performance criteria are not probable, then no further compensation cost will be recorded and any previous costs will be reversed.

At June 30, 2012, the Company had $77,399,000 of total unrecognized compensation expense, net of estimated forfeitures, related to stock options and RSUs that will be recognized over a weighted-average period of approximately three years.
 

SHUTTERFLY, INC.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

Note 3 — Net Loss Per Share

Basic net loss per share is computed by dividing the net loss attributable to common shares for the period by the weighted average number of common shares outstanding during the period.

Diluted net loss per share attributed to common shares is computed by dividing the net loss attributable to common shares for the period by the weighted average number of common and potential common shares outstanding during the period, if the effect of each class of potential common shares is dilutive. Potential common shares include restricted common stock units and incremental shares of common stock issuable upon the exercise of stock options.

A summary of the net loss per share for the three and six months ended June 30, 2012 and 2011 is as follows (in thousands, except per share amounts):
 
   
Three Months Ended
   
Six Months Ended
 
   
June 30,
   
June 30,
 
   
2012
   
2011
   
2012
   
2011
 
Net loss per share:
 
 
 
 
 
 
 
 
 
 
 
 
Numerator
 
 
 
 
 
 
 
 
 
 
 
 
Net loss
 
$
(9,511
)
 
$
(3,650
)
 
$
(19,551
)
 
$
(11,410
)
Denominator for basic and diluted net loss per share                                
Weighted-average common shares outstanding
 
 
35,812
 
 
 
33,160
 
 
 
35,506
 
 
 
30,917
 
Net loss per share — basic and diluted
 
$
(0.27
)
 
$
(0.11
)
 
$
(0.55
)
 
$
(0.37
)

The following weighted-average outstanding stock options and restricted stock units were excluded from the computation of diluted net loss per common share for the periods presented because including them would have had an anti-dilutive effect (in thousands):

 
 
Three Months Ended
 
 
Six Months Ended
 
 
 
June 30,
 
 
June 30,
 
 
 
2012
 
 
2011
 
 
2012
 
 
2011
 
Stock options and restricted stock units
 
 
5,206
 
 
 
5,605
 
 
 
5,148
 
 
 
5,966
 

Note 4 — Balance Sheet Components

Prepaid Expenses and Other Current Assets
 
 
 
June 30,
2012
 
 
December 31,
2011
 
 
 
(in thousands)
 
Intra-period deferred tax asset
 
$
30,982
 
 
$
-
 
Prepaid service contracts – current portion
 
 
5,440
 
 
 
4,727
 
Prepaid income taxes
 
 
1,020
 
 
 
1,952
 
Other prepaid expenses and current assets
 
 
5,878
 
 
 
7,191
 
 
 
$
43,320
 
 
$
13,870
 
 
Intra-period tax asset represents the cumulative income tax benefit recorded as of the balance sheet date, which will offset against taxes payable or become a component of deferred taxes on a full year basis.
 

SHUTTERFLY, INC.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

Property and Equipment

 
 
June 30,
2012
 
 
December 31,
2011
 
 
 
(in thousands)
 
Computer and other equipment
 
$
111,606
 
 
$
102,061
 
Software
 
 
15,656
 
 
 
12.579
 
Leasehold improvements
 
 
9,750
 
 
 
9,559
 
Furniture and fixtures
 
 
3,797
 
 
 
3,762
 
Capitalized software and website development costs
 
 
42,029
 
 
 
35,842
 
 
 
 
182,838
 
 
 
163,803
 
Less: Accumulated depreciation and amortization
 
 
(116,477
)
 
 
(109,680
)
Net property and equipment
 
$
66,361
 
 
$
54,123
 
 
Depreciation and amortization expense totaled $6,730,000 and $5,672,000 for the three months ended June 30, 2012 and 2011, respectively. Depreciation and amortization expense totaled $12,741,000 and $10,786,000 for the six months ended June 30, 2012 and 2011, respectively.
  
Accrued Liabilities
 
 
 
June 30,
  2012
 
 
December 31,
2011
 
 
 
(in thousands)
 
Accrued compensation
 
$
7,362
 
 
$
5,485
 
Accrued marketing expenses
 
 
5,443
 
 
 
19,072
 
Accrued income and sales taxes
   
4,503
     
11,106
 
Accrued production costs
 
 
3,703
 
 
 
16,939
 
Accrued consulting
 
 
1,549
 
 
 
1,861
 
Accrued other
 
 
9,373
 
 
 
4,808
 
 
 
$
31,933
 
 
$
59,271
 
 
Included in Accrued other is the remaining payment of $4.8 million which is due upon completion of the transition of Kodak Gallery customer accounts and images.
 
Note 5 — Commitments and Contingencies

Indemnifications

In the normal course of business, the Company enters into contracts and agreements that contain a variety of representations and warranties and provide for general indemnifications. The Company’s exposure under these agreements is unknown because it involves future claims that may be made against the Company, but have not yet been made. To date, the Company has not paid any claims or been required to defend any action related to its indemnification obligations. However, the Company may record charges in the future as a result of these indemnification obligations.

Contingencies

From time to time, the Company may have certain contingent liabilities that arise in the ordinary course of its business activities. The Company accrues contingent liabilities when it is probable that future expenditures will be made and such expenditures can be reasonably estimated.
 

SHUTTERFLY, INC.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

Legal Matters

On December 10, 2010, Eastman Kodak Company (“Kodak”) filed a complaint for alleged patent infringement against the Company in Eastman Kodak Company v. Shutterfly, Inc., C.A. No. 10-1079-SLR, in the U.S. District Court for the District of Delaware. The complaint asserts infringement of U.S. Patents Nos. 6,549,306; 6,600,572; 7,202,982; 6,069,712; and 6,512,570, which claim among other things, methods for selecting photographic images using index prints, an image handling system incorporating coded instructions, and processing a roll of exposed photographic film into corresponding visual prints and distributing such prints. The Complaint asserts that the Company directly or indirectly infringes the patents without providing any details concerning the alleged infringement, and it seeks unspecified damages and injunctive relief. The Company believes the suit is without merit and will defend itself vigorously.  On February 3, 2011, the Company filed an answer and counterclaims against Kodak. On November 16, 2011, Kodak filed its First Amended Complaint adding Tiny Prints, Inc. as a defendant. On December 13, 2011, the Company and Tiny Prints, Inc. each filed its answer and counterclaims against Kodak. A trial date is currently set for on or around October 21, 2013.  In light of the provisions of federal bankruptcy law, the Company has requested that the court stay the entirety of Eastman Kodak Company v. Shutterfly, Inc., C.A. No. 10-1079-SLR.

On January 31, 2011, the Company filed a complaint for patent infringement against Eastman Kodak Company and Kodak Imaging Network, Inc. in Shutterfly, Inc. v. Eastman Kodak Company and Kodak Imaging Network, Inc., C.A. No. 11-099-SLR, in the U.S. District Court for the District of Delaware. The complaint asserts infringement of U.S. Patents Nos. 6,583,799; 7,269,800; 6,587,596; 6,973,222; 7,474,801; 7,016,869; and 7,395,229, which claim among other things, methods for image uploading, image cropping, automatic generation of photo albums, and changing attributes of an image-based product. The Complaint asserts that Kodak directly or indirectly infringes the patents, and it seeks unspecified damages and injunctive relief. On March 24, 2011, Kodak filed an answer and counterclaims against the Company. On November 16, 2011, the Company filed its First Amended Complaint to include U.S. Patent No. 7,243,079. On the same day, November 16, 2011, Kodak filed its answer. Upon Kodak’s filing of a Chapter 11 petition on January 19, 2012, Shutterfly, Inc. v. Eastman Kodak Company and Kodak Imaging Network, Inc., C.A. No. 11-099-SLR was automatically stayed pursuant to provisions of federal bankruptcy law. On January 30, 2012, the Company filed a Notice of Suggestion of Bankruptcy, suggesting that the Company’s counterclaims and affirmative defenses also be automatically stayed.

On September 10, 2011, Princeton Digital Image Corporation (“Princeton”) filed a complaint for alleged patent infringement against the Company and seven other defendants in Princeton Digital Image Corporation v. Facebook, Inc. et al., Civ. No. 2:2011cv00400, in the Eastern District of Texas, Tyler Division. The complaint asserts infringement of U.S. Patent No. 4,813,056, which claims, among other things, a method for encoding user’s images. The Complaint asserts that the Company directly or indirectly infringes the patent without providing any details concerning the alleged infringement, and it seeks unspecified damages and injunctive relief. On September 12, 2011 Princeton filed a First Amended Complaint adding additional defendants.  On January 23, 2012, the Company filed its Answer to Princeton’s First Amended Complaint, and on March 12, 2012, the Company filed a Motion to Transfer Venue to the U.S. District Court for the Northern District of California.
 
In all cases, at each reporting period, the Company evaluates whether or not a potential loss amount or a potential range of loss is probable and reasonably estimable under the provisions of the authoritative guidance that addresses accounting for contingencies. In such cases, the Company accrues for the amount, or if a range, the Company accrues the low end of the range as a component of legal expense. The Company monitors developments in these legal matters that could affect the estimate it has previously accrued.  There are no amounts accrued which the Company believes would be material to its financial position and results of operations.
 
Note 6 — Acquisitions

Purchased Intangible Assets

Eastman Kodak Gallery Assets

On March 1, 2012, the Company entered into an agreement with Eastman Kodak Company (“Kodak”) for the proposed sale of certain assets of its Kodak Gallery online photo services business for $23.8 million through a court-supervised auction process. On April 30, 2012, the transaction was approved by the bankruptcy court and on May 2, 2012 the transaction closed.  The Company paid $19.0 million as of June 30, 2012 and the remaining $4.8 million is to be paid at the end of the transition period, but not later than nine months from the acquisition date.  This acquisition was accounted for as an asset acquisition and as such the Company has capitalized transaction costs of approximately $0.6 million, for a total purchase price of $24.4 million.  The purchase price was allocated to a single asset, customer list, which will be amortized over its useful life of four years.
 
 
Business Combination

Photoccino Ltd.

On May 25, 2012, the Company acquired Photoccino Ltd. (“Photoccino”) for a total aggregate cash purchase price of $4.6 million. Photoccino has developed technologies for photo ranking, analysis and organization which will allow customers to more efficiently organize and select the best photos from their archives so they can quickly and easily create photo books, calendars, cards, and photo gifts. Photoccino’s technology applies proprietary algorithms to analyze and evaluate the quality and content of photos, ranks them, and automatically creates photo products using the customer’s best images. The acquisition was accounted for as a non-taxable purchase transaction and, accordingly, the purchase price has been allocated to the acquired tangible assets, liabilities assumed, and identifiable intangible assets acquired based on their estimated fair values on the acquisition date. The excess of the purchase price over the aggregate fair values was recorded as goodwill. In addition, restricted stock awards were granted to certain Photoccino employees contingent upon their continued employment for a period of three years and will be recorded as stock-based compensation over the vesting period.

Of the total purchase price, $3.0 million was allocated to developed technology and is being amortized over an estimated useful life of five years, $0.7 million was allocated to in-process research and development, and $80,000 was allocated to non-compete agreements with the founders which will be amortized over an estimated useful life of two years. The assets and liabilities acquired totaled approximately $0.1 million. The remaining excess purchase price of approximately $0.7 million was allocated to goodwill primarily representing the assembled workforce. In addition, $950,000 was recorded as a deferred tax liability representing the difference between the assigned values of the assets acquired and the tax basis of those assets, with the offset recorded as additional goodwill. The results of operations for the acquired business have been included in the consolidated statement of operations for the period subsequent to the Company’s acquisition of Photoccino. Photoccino’s results of operations for periods prior to this acquisition were not material to the consolidated statement of operations and, accordingly, pro forma financial information has not been presented.
 

CAUTIONARY NOTE REGARDING FORWARD-LOOKING STATEMENTS

This document, including the following Management’s Discussion and Analysis of Financial Condition and Results of Operations, contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934 that are based upon our current expectations. These forward-looking statements include statements related to our expectations regarding the seasonality and growth of our business, the impact on us of general economic conditions, trends in key metrics such as number of customers and orders and average order value, the decline in average selling prices for prints, our capital expenditures for 2012, the sufficiency of our cash and cash equivalents and cash generated from operations for the next 12 months, our operating expenses remaining a consistent percentage of our net revenues, as well as other statements regarding our future operations, financial condition and prospects and business strategies. In some cases, you can identify forward-looking statements by terminology such as “project,” “believe,” “anticipate,” “plan,” “expect,” “estimate,” “intend,” “continue,” “should,” “would,” “could,” “potentially,” “will,” or “may,” or the negative of these terms or other comparable terminology. Forward-looking statements involve risks and uncertainties. Our actual results and the timing of events could differ materially from those anticipated in our forward-looking statements as a result of many factors, including but not limited to, the seasonality of our business, whether we are able to expand our customer base and increase our product and service offering, competition in our marketplace and the other risks set forth below under “Risk Factors” in Part II, Item 1A of this report. Given these risks and uncertainties, readers are cautioned not to place undue reliance on such forward-looking statements. We assume no obligation to update any of the forward-looking statements after the date of this report or to compare these forward-looking statements to actual results.

Overview
 
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.  Our primary focus is on helping consumers manage their memories through the powerful medium of photography. We provide a full range of personalized photo-based products and services that make it easy, convenient and fun for consumers to upload, edit, enhance, organize, find, share, create, print, and preserve their memories in a creative and thoughtful manner.

We are building four trusted lifestyle brands:  Shutterfly, Tiny Prints, Wedding Paper Divas, and Treat.  We have operated the Shutterfly.com brand since inception in 1999.  In 2011, we acquired Tiny Prints, Inc. a privately-held company based in Sunnyvale, California that operated tinyprints.com and weddingpaperdivas.com, two growing ecommerce brands primarily offering stylish cards, invitations and personalized stationery.  On April 16, 2012, we launched Treat.com, a destination that enables users to easily personalize and send unique greeting cards. Our Treat launch signifies our focused expansion into the one-to-one U.S. greeting card market, to complement our existing one-to-many card business.  And in May 2012, we acquired the customer accounts and images of Kodak Gallery’s online photo service through a bankruptcy court supervised auction.  In July 2012, we began the process to transfer the more than five billion Kodak Gallery customer photos onto the Shutterfly technology platform.

In addition, on May 25, 2012, we acquired Photoccino Ltd. (“Photoccino”), a privately-held company based in Haifa, Israel, which has developed ground breaking technologies for photo ranking, analysis and organization which will allow customers to more efficiently organize and select the best photos from their ever-increasing archives so they can quickly and easily create photo books, calendars, cards, and photo gifts. Photoccino’s technology applies proprietary algorithms to analyze and evaluate the quality and content of photos, ranks them, and automatically creates photo products using the customer’s best images.  We expect to integrate the Photoccino technology into the products and services that our brands offer.

We currently generate the majority of our revenues by producing and selling professionally-bound photo books, greeting and stationery cards, personalized calendars, other photo-based merchandise and high-quality prints ranging in size from wallet-sized to jumbo-sized 20x30 enlargements. We manufacture most of these items in our Charlotte, North Carolina and Phoenix, Arizona production facilities.  By controlling the production process in our own production facilities, we are able to produce high-quality products, innovate rapidly, maintain a favorable cost structure and ensure timely shipment to customers, even during peak periods of demand. Additionally, we sell a variety of photo-based merchandise that is currently manufactured for us by third parties, such as calendars, mugs, canvas prints, mouse pads, magnets, and puzzles.  We generate substantially all of our revenue from sales originating in the United States and our sales cycle has historically been highly seasonal as we generate more than 50% of our revenue during our fiscal fourth quarter.

Our high-quality products and services and the compelling online experience we create for our customers, combined with our focus on continuous innovation, have allowed us to establish a premium brand. We realize the benefits of a premium brand through high customer loyalty, low customer acquisition costs and premium pricing.

Our customers are a central part of our business model. They generate most of the content on our service by uploading their photos and storing their memories. In addition, they share their photos electronically with their friends and families, extending and endorsing our brand and creating a sense of community. Finally, by giving our branded products to colleagues, friends and loved ones throughout the year, customers reinforce our brands. Through these various activities, our customers create a viral network of new users and customers.

In addition to driving lower customer acquisition costs through viral marketing, our customers provide input on new features, functionalities and products. Close, frequent customer interactions, coupled with significant investments in sophisticated integrated marketing programs, enable us to fine-tune and tailor our promotions and website presentation to specific customer segments. Consequently, customers are presented with a highly personalized shopping experience, which helps foster a unique and deep relationship with our brands.
 
 
Our operations and financial performance depend on general economic conditions in the United States.  The U.S. economy is experiencing a slow economic recovery from a deep recession and concerns about that recovery could further impact consumer sentiment and consumer discretionary spending.  We closely monitor these economic measures as their trends are indicators of the health of the overall economy and are some of the key external factors that impact our business.

Basis of Presentation

Net Revenues.      In the second quarter of 2012, we changed the categories within net revenues by consolidating our Personalized Products and Services (PPS) and Prints revenue into a single category called Consumer. We have also renamed our Commercial Printing net revenue category as Enterprise. Our net revenues are now comprised of sales generated from Consumer and Enterprise categories. All prior periods included below now reflect the new presentation of net revenues categories.
 
Consumer
Our Consumer revenues include sales from all of our brands and are derived from the sale of photo-based products, such as photo books, stationery and greeting cards, other photo-based merchandise, photo prints, and the related shipping revenues.  Included in our photo-based merchandise are items such as mugs, mouse pads, desktop plaques and puzzles.  Photo prints consist of wallet, 4x6, 5x7, 8x10, and large format sizes.  Revenue from advertising displayed on our website is also included in Consumer revenues.
 
Enterprise
Our Enterprise revenues are primarily from variable, four-color direct marketing collateral manufactured and fulfilled for business customers.  We continue to focus our efforts in expanding our presence in this market.
 
All of our Consumer revenue is recorded net of estimated returns, promotions redeemed by customers and other discounts. Customers place orders through our website and pay primarily using credit cards.  Advertising and Enterprise customers are invoiced upon fulfillment.

Our business is subject to seasonal fluctuations. In particular, we generate a substantial portion of our revenues during the holiday season in the calendar fourth quarter. We also typically experience increases in net revenues during other shopping-related seasonal events, such as Easter, Mother’s Day, Father’s Day, and Halloween. We generally experience lower net revenues during the first, second and third calendar quarters and have incurred and may continue to incur losses in these quarters. Due to the relatively short lead time required to fulfill product orders, usually one to three business days, order backlog is not material to our business.
 
To further understand net revenue trends in our Consumer category, we monitor several key metrics including, total customers, number of orders, and average order value.  In the second quarter of 2012, we changed our disclosures of these metrics to be the aggregate of all customers and orders across all our Consumer brands, instead of our previous, separate disclosures of Shutterfly and Tiny Prints customers and orders.  As a result, our average order value metric is also presented in the aggregate for all brands.

Total Customers.     We closely monitor total customers as a key indicator of demand.  Total customers include the number of transacting customers in a given period.  We seek to expand our customer base by empowering our existing customers with sharing and collaboration services (such as Shutterfly Gallery and Shutterfly Share Sites), and by conducting integrated marketing and advertising programs.

Total Number of Orders.     We closely monitor the total number of orders as a leading indicator of net revenue trends. We recognize the net revenues associated with an order when the products have been shipped and all other revenue recognition criteria have been met. Orders are typically processed and shipped within two business days after a customer places an order.
 
Average Order Value.     Average order value is Consumer net revenues for a given period divided by the total number of customer orders recorded during that same period.
 
The table below highlights the trends of each of these aggregated metrics, as they are now presented, for the last four quarters covering the period since the Tiny Prints acquisition.  In addition, we have provided pro forma metrics covering the three month period ended June 30, 2011 as the acquisition of Tiny Prints closed on April 25, 2011.
 
   
Three Months Ended
 
   
Jun. 30,
2011
   
Sep. 30,
2011
   
Dec. 31,
2011
   
Mar. 31,
2012
   
Jun. 30,
2012
 
   
(Pro-Forma)
                         
    (in thousands, except AOV amounts)  
Customers
    1,668       1,600       3,226       1,880       1,894  
Orders
    2,597       2,577       5,190       2,840       2,978  
Average order value
  $ 30.33     $ 28.18     $ 49.93     $ 29.97     $ 31.70  
 
We believe the analysis of these metrics and others provides us with important information on our overall net revenue trends and operating results. Fluctuations in these metrics are not unusual and no single factor is determinative of our net revenues and operating results.
 
 
Cost of Net Revenues.       Cost of net revenues consists primarily of direct materials (the majority of which consists of paper, ink, and photo book covers), payroll and related expenses for direct labor, shipping charges, packaging supplies, distribution and fulfillment activities, rent for production facilities, depreciation of production equipment, and third-party costs for photo-based merchandise. Cost of net revenues also includes payroll and related expenses for personnel engaged in customer service, any third-party software or patents licensed, as well as the amortization of acquired developed technology, capitalized website and software development costs, and patent royalties.  Cost of net revenues also includes certain costs associated with facility closures and restructuring.

Operating Expenses.       Operating expenses consist of technology and development, sales and marketing, and general and administrative expenses. We anticipate that each of the following categories of operating expenses will increase in absolute dollar amounts, but remain relatively consistent as a percentage of net revenues.

Technology and development expense consists primarily of personnel and related costs for employees and contractors engaged in the development and ongoing maintenance of our website, infrastructure and software. These expenses include depreciation of the computer and network hardware used to run our website and store the customer data, as well as amortization of purchased software. Technology and development expense also includes co-location, power and bandwidth costs.

Sales and marketing expense consists of costs incurred for marketing programs, and personnel and related expenses for our customer acquisition, product marketing, business development, and public relations activities. Our marketing efforts consist of various online and offline media programs, such as e-mail and direct mail promotions, the purchase of keyword search terms and various strategic alliances. We depend on these efforts to attract customers to our service.

General and administrative expense includes general corporate costs, including rent for our corporate offices, insurance, depreciation on information technology equipment, and legal and accounting fees. Transaction costs are also included in general and administrative expense. In addition, general and administrative expense includes personnel expenses of employees involved in executive, finance, accounting, human resources, information technology and legal roles. Third-party payment processor and credit card fees are also included in general and administrative expense and have historically fluctuated based on revenues during the period. All of the payments we have received from our intellectual property license agreements have been included as an offset to general and administrative expense.

Interest Expense.       Interest expense consists of costs associated with our 5-year syndicated line of credit facility that became effective in November 2011.

Interest and other income, net.   Interest and other income, net primarily consists of the interest earned on our cash and investment accounts.

Income Taxes.       We account for income taxes under the liability method. Under this method, deferred tax assets and liabilities are determined based on the difference between the financial statement and tax basis of assets and liabilities.
 
 Critical Accounting Policies and Estimates

The discussion and analysis of our financial condition and results of operations are based upon our unaudited condensed consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses. On an on-going basis, we evaluate our critical accounting policies and estimates. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. Our critical accounting policies and estimates are discussed in our Annual Report on Form 10-K for the fiscal year ended December 31, 2011.
 

Results of Operations

The following table presents the components of our income statement as a percentage of net revenues:

 
 
Three Months Ended
 
 
Six Months Ended
 
 
 
June 30,
 
 
June 30,
 
 
 
2012
 
 
2011
 
 
2012
 
2011
 
Net revenues
 
 
100
%
 
 
100
%
 
 
100
%
 
 
100
%
Cost of net revenues
 
 
51
%
 
 
53
%
 
 
53
%
 
 
52
%
Gross profit
 
 
49
%
 
 
47
%
 
 
47
%
 
 
48
%
Operating expenses:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Technology and development
 
 
21
%
 
 
22
%
 
 
21
%
 
 
23
%
Sales and marketing
 
 
30
%
 
 
33
%
 
 
30
%
 
 
29
%
General and administrative
 
 
16
%
 
 
20
%
 
 
16
%
 
 
22
%
Total operating expenses
 
 
67
%
   
75
%
   
67
%
   
74
%
Loss from operations
 
 
(18
)%
 
 
(28
)%
 
 
(20
)%
 
 
(26
)%
Interest expense
 
 
0
%
 
 
0
%
 
 
0
%
 
 
0
%
Interest and other income, net
 
 
0
%
 
 
0
%
 
 
0
%
 
 
0
%
Loss before income taxes
 
 
(18
)%
 
 
(28
)%
 
 
(20
)%
 
 
(26
)%
Benefit from income taxes
 
 
8
%
 
 
23
%
 
 
10
%
 
 
17
%
Net loss
 
 
(10
)%
 
 
(5
)%
 
 
(10
)%
 
 
(9
)%

Comparison of the Three Month Periods Ended June 30, 2012 and 2011
 
 
 
Three Months Ended June 30,
 
 
 
2012
 
 
2011
 
 
$ Change
 
 
% Change
 
 
 
(in thousands)
 
Net revenues
                               
Consumer
 
$
94,422
   
$
73,022
   
$
21,400
     
29
%
Enterprise
   
4,598
     
2,742
     
1,856
     
68
 
Total net revenues
   
99,020
     
75,764
     
23,256
     
31
 
Cost of net revenues
   
50,710
 
   
39,881
 
   
10,829
 
 
 
27
 
Gross profit
 
$
48,310
 
 
$
35,883
 
 
$
12,427
 
 
 
35
%
Percentage of net revenues
 
 
49
%
 
 
47
%
 
 
 
 
 
 
 
Net revenues increased $23.3 million, or 31% for the three months ended June 30, 2012 as compared to the same period in 2011. Consumer net revenues increased $21.4 million or 29% in the three months ended June 30, 2012 compared to the same period in 2011.  The increase in Consumer revenue is primarily a result of increased sales of greeting and stationery cards and photo books.  The increase in Consumer revenue is also a result of the addition of Tiny Prints sales during the three months ended June 30, 2012 while the three months ended June 30, 2011 only included Tiny Prints sales from April 25 to June 30, 2011. Enterprise revenues increased $1.9 million or 68% in the three months ended June 30, 2012 compared to the same period in 2011.
 
On a pro forma basis (as the acquisition of Tiny Prints was completed on April 25, 2011), Consumer net revenue increases were also the result of year-over-year increases in our key metrics as outlined below.

 
 
Three Months Ended June 30,
 
 
 
2012
 
 
2011
 
 
$ Change
 
 
% Change
 
   
(in thousands, except AOV amounts)
 
Customers
 
 
1,894
 
 
 
1,668
 
 
 
226
 
 
 
14
%
Orders
 
 
2,978
 
 
 
2,597
 
 
 
381
 
 
 
15
%
Average order value
 
$
31.70
 
 
$
30.33
 
 
$
1.37
 
 
 
5
%
 
Cost of net revenues increased $10.8 million, or 27%, for the three months ended June 30, 2012 as compared to the same period in 2011. As a percentage of net revenues, cost of net revenues decreased to 51% in the three months ended June 30, 2012 from 53% in the same period in 2011, which increased gross margin to 49% in the three months ended June 30, 2012 from 47% in the same period in 2011. Overall, the increase in cost of net revenues was primarily the result of the increased volume of shipped products and increased headcount. These costs were partially offset by favorable changes in product mix and cost efficiencies in manufacturing.
 
 
 
 
Three Months Ended June 30,
 
 
 
2012
 
 
2011
 
 
$ Change
 
 
% Change
 
 
 
(in thousands)
 
Technology and development
 
$
20,930
 
 
$
16,971
 
 
$
3,959
 
 
 
23
%
Percentage of net revenues
 
 
21
%
 
 
22
%
 
 
-
 
 
 
-
 
Sales and marketing
 
$
30,002
 
 
$
24,930
 
 
$
5,072
 
 
 
20
%
Percentage of net revenues
 
 
30
%
 
 
33
%
 
 
-
 
 
 
-
 
General and administrative
 
$
15,164
 
 
$
15,522
 
 
$
(358
)
 
 
(2
)%
Percentage of net revenues
 
 
16
%
 
 
20
%
 
 
-
 
 
 
-
 

Our technology and development expense increased $4.0 million, or 23%, for the three months ended June 30, 2012, compared to the same period in 2011. As a percentage of net revenues, technology and development expense decreased to 21% for the three months ended June 30, 2012 from 22% for the same period in 2011. The increase in technology and development expense was primarily due to an increase of $2.2 million related to facilities costs. The overall increase was also due to an increase of $1.7 million related to personnel and related costs and an increase of $0.6 million in depreciation expense. These factors were partially offset by an increase of $0.4 million in website development costs capitalized in the current period compared to the same period in the prior year.

At June 30, 2012, headcount in technology and development increased by 13% compared to June 30, 2011, reflecting our strategic focus to increase the rate of innovation in our product and services offerings, to generate greater differentiation from our competitors, and improve our long-term operating efficiency. In the three months ended June 30, 2012, we capitalized $2.8 million in eligible salary and consultant costs, including $0.2 million of stock-based compensation, associated with software developed or obtained for internal use, compared to $2.4 million, which included $0.1 million of stock-based compensation capitalized in the three months ended June 30, 2011.  We expect this trend to continue in 2012, further increasing capitalized website and software development costs as a percentage of our total capital expenditures.

Our sales and marketing expense increased $5.1 million, or 20%, in the three months ended June 30, 2012 compared to the same period in 2011. The increase in sales and marketing expense was primarily due to an increase of $3.4 million related to expanded online marketing campaigns and advertising.  The increase is also attributable to an increase of $1.6 million in personnel and related costs associated with the expansion of our internal marketing team and an increase of $1.5 million in intangible asset amortization primarily from the Kodak Gallery customer list. These factors were partially offset by a decrease of $1.4 million of stock-based compensation. As a percentage of net revenues, total sales and marketing expense decreased to 30% in the three months ended June 30, 2012 from 33% for the same period in 2011. Excluding stock-based compensation and amortization of intangibles, sales and marketing expense was 24% of net revenues for the three months ended June 30, 2012, and approximately in line with 25% of net revenues in the same period of 2011.

Our general and administrative expense decreased $0.4 million, or 2%, in the three months ended June 30, 2012 as compared to the same period in 2011. As a percentage of net revenues, total general and administrative expense decreased to 16% in the three months ended June 30, 2012 from 20% for the comparable period in 2011. The decrease in general and administrative expense is primarily due to a decrease in professional fees of $0.4 million which was largely due to transaction costs related to our acquisition of Tiny Prints incurred in the three months ended June 30, 2011, a decrease in stock-based compensation of $0.8 million, and a gain on disposition of assets of $0.2 million. These decreases were partially offset by an increase in personnel related costs of $0.4 million as a result of increased headcount, an increase of $0.2 million related to facilities costs, and an increase in credit card fees of $0.2 which was driven by the increase in Consumer product revenue as compared to the prior year.

 
 
Three Months Ended June 30,
 
 
 
2012
 
 
2011
 
 
Change
 
 
 
(in thousands)
 
Interest expense
 
$
(156
)
 
$
-
 
 
$
(156
)
Interest and other income, net
 
$
9
 
 
$
6
 
 
$
3
 

Interest expense increased in the three months ended June 30, 2012 as compared to the same period in 2011 primarily due to origination and ongoing commitment fees from our 5-year syndicated line of credit facility that became effective in November 2011.

 
 
Three Months Ended
June 30,
 
 
 
2012
 
 
2011
 
 
 
(in thousands)
 
Income tax benefit
 
$
8,442
 
 
$
17,884
 
Effective tax rate
 
 
47
%
 
 
83
%

The benefit for income taxes was $8.4 million for the three months ended June 30, 2012, compared to a benefit of $17.9 million for the three months ended June 30, 2011.  Our effective tax rate was 47% in the three months ended June 30, 2012, compared to 83% in the same period in 2011, and includes the impact of disqualifying dispositions of incentive stock options.
 

At June 30, 2012, we had approximately $41.1 million, $55.1 million, and $20.3 million of federal, California, and other state jurisdictions net operating loss carryforwards, respectively, to reduce future taxable income, $39.5 million, $29.9 million and $20.3 million of which is associated with windfall tax benefits, respectively, that will be recorded as additional paid-in capital when realized. These carryforwards will expire beginning in the year 2028 and 2015 for federal and California purposes, respectively, and no sooner than 2022 for the portion related to 15 other state jurisdictions, if not utilized.
 
   
Three Months Ended June 30,
 
   
2012
   
2011
   
$ Change
   
% Change
 
   
(in thousands)
 
Loss before income taxes
  $ (17,993 )   $ (21,534 )   $ 3,541       (16 )%
Net loss
  $ (9,511 )   $ (3,650 )   $ (5,861 )     161 %
Percentage of net revenues
    (10 ) %     (5 ) %            

Net loss increased by $5.9 million for the three months ended June 30, 2012 as compared to the same period in 2011. As a percentage of net revenues, net loss was 10% and 5% for the three months ended June 30, 2012 and June 30, 2011, respectively.

Comparison of the Six Month Period Ended June 30, 2012 and 2011

 
 
Six Months Ended June 30,
 
 
 
2012
 
 
2011
 
 
$ Change
 
 
% Change
 
 
 
(in thousands)
 
Net revenues
                               
Consumer
 
$
179,532
   
$
127,974
   
$
51,558
     
40
%
Enterprise
   
10,779
     
5,019
     
5,760
     
115
 
Total net revenues
   
190,311
     
132,993
     
57,318
     
43
 
Cost of net revenues
   
100,763
 
   
69,427
 
   
31,336
 
 
 
45
 
Gross profit
 
$
89,548
 
 
$
63,566
 
 
$
25,982
 
 
 
41
%
Percentage of net revenues
 
 
47
%
 
 
48
%
 
 
 
 
 
 

Net revenues increased $57.3 million, or 43%, for the six months ended June 30, 2012 as compared to the same period in 2011. Consumer net revenues increased $51.6 million or 40% in the six months ended June 30, 2012 compared to the same period in 2011. The increase in Consumer revenue is primarily a result of increased sales of greeting and stationery cards and photo books as well as the addition of Tiny Prints sales during the six months ended June 30, 2012 while the six months ended June 30, 2011 only included Tiny Print sales from April 25 to June 30, 2011.  Enterprise revenues increased $5.8 million or 115% in the six months ended June 30, 2012 compared to the same period in 2011.
 
Cost of net revenues increased $31.3 million, or 45%, for the six months ended June 30, 2012 as compared to the same period in 2011. As a percentage of net revenues, cost of net revenues increased slightly to 53% in 2012 from 52% in 2011, which decreased gross margin to 47% in the six months ended June 30, 2012 from 48% in the same period in 2011. Overall, the increase in cost of net revenues was primarily the result of the increased volume of shipped products and increased headcount, as well as additional third party fulfillment costs associated with Tiny Prints products. These costs were partially offset by favorable improvements from product mix.

 
 
Six Months Ended June 30,
 
 
 
2012
   
2011
   
$ Change
   
% Change
 
 
 
(in thousands)
 
Technology and development
  $ 39,438     $ 30,084     $ 9,354       31 %
Percentage of net revenues
    21 %     23 %     -       -  
Sales and marketing
  $ 57,040     $ 39,195     $ 17,845       46 %
Percentage of net revenues
    30 %     29 %     -       -  
General and administrative
  $ 29,936     $ 28,813     $ 1,123       4 %
Percentage of net revenues
    16 %     22 %     -       -  

Our technology and development expense increased $9.4 million, or 31%, for the six months ended June 30, 2012, as compared to the same period in 2011. As a percentage of net revenues, technology and development expense decreased to 21% for the six months ended June 30, 2012 from 23% for the same period in 2011. The increase in technology and development expense was primarily due to an increase of $4.8 million related to personnel and related costs for employees, reflecting the addition of the Tiny Prints technology team.  The overall increase was also due to an increase of $2.7 million related to facilitates costs, an increase of $1.5 million of stock-based compensation, an increase of $0.7 million related to professional consultants to support website development and infrastructure, and an increase of $0.9 million in depreciation expense. These factors were partially offset by an increase of $1.3 million in website development costs capitalized in the current period compared to the same period in the prior year.

In the six months ended June 30, 2012, we capitalized $6.0 million in eligible salary and consultant costs, including $0.4 million of stock-based compensation, associated with software developed or obtained for internal use, compared to $4.7 million, which included $0.2 million of stock-based compensation capitalized in the six months ended June 30, 2011.  We expect this trend to continue in 2012, further increasing capitalized website and software development costs as a percentage of our total capital expenditures.
 

Our sales and marketing expense increased $17.8 million, or 46%, in the six months ended June 30, 2012 compared to the same period in 2011.  As a percentage of net revenues, total sales and marketing expense increased to 30% for the six months ended June 30, 2012 from 29% for the same period in 2011. The increase in sales and marketing expense was primarily due to an increase of $9.3 million related to expanded online marketing campaigns and advertising. The increase is also attributable to an increase of $4.1 million in personnel and related costs associated with the expansion of our internal marketing team including the addition of Tiny Prints headcount, an increase of  $3.9 million in intangible asset amortization primarily from the Tiny Prints acquisition and the Kodak Gallery customer list acquisition, and an increase of $0.4 million in stock-based compensation. Excluding stock-based compensation and amortization of intangibles, sales and marketing expense was 24% of net revenues for the six months ended June 30, 2012, and approximately in line with 25% of net revenues in the same period of 2011.

Our general and administrative expense increased $1.1 million, or 4%, in the six months ended June 30, 2012 as compared to the same period in 2011.  As a percentage of net revenues, total general and administrative expense decreased to 16% in the six months ended June 30, 2012 from 22% for the comparable period in 2011. The increase in general and administrative expense is primarily due to an increase in personnel related costs of $1.7 million as a result of increased headcount.  We also incurred an increase in credit card fees of $0.8 million which was driven by the increase in Consumer product revenue as compared to the prior year, an increase in facilities costs of $0.4 million, an increase of $0.3 million in depreciation expense, and an increase in stock-based compensation of $0.2 million.  These increases were partially offset by a decrease in professional fees of $1.8 million which was largely due to transaction costs related to our acquisition of Tiny Prints incurred in the six months ended June 30, 2011 and gain on disposition of assets of $0.6 million.
 
 
 
Six Months Ended June 30,
 
 
 
2012
 
 
2011
 
 
Change
 
 
 
(in thousands)
 
Interest expense
 
$
(308
)
 
$
-
 
 
$
(308
)
Interest and other income, net
 
$
16
 
 
$
20
 
 
$
(4
)

Interest expense increased in the six months ended June 30, 2012 as compared to the same period in 2011 primarily due to origination and ongoing commitment fees from our 5-year syndicated line of credit facility that became effective in November 2011.
 
     
Six Months Ended June 30,
 
     
2012
     
2011
 
     
(in thousands)
 
Income tax benefit
 
$
17,607
 
 
$
23,096
 
Effective tax rate
 
 
47
%
 
 
67
%

The benefit for income taxes was $17.6 million for the six months ended June 30, 2012, compared to a benefit of $23.1 million for the six months ended June 30, 2011.  Our effective tax rate was 47% in the six months ended June 30, 2012, compared to 67% in the same period in 2011, which includes the impact of disqualifying dispositions of employee incentive stock options during the period.
 
   
Six Months Ended June 30,
 
   
2012
   
2011
   
$ Change
   
% Change
 
   
(in thousands)
 
Loss before income taxes
  $ (37,158 )   $ (34,506 )   $ (2,652 )     8 %
Net loss
  $ (19,551 )   $ (11,410 )   $ (8,141 )     71 %
Percentage of net revenues
    (10 ) %     (9 ) %            

Net loss increased by $8.1 million for the six months ended June 30, 2012 as compared to the same period in 2011. As a percentage of net revenue, net loss was 10% and 9% for the six months ended June 30, 2011 and June 30, 2010, respectively.

Liquidity and Capital Resources

 At June 30, 2012, we had $118.1 million of cash and cash equivalents. In addition, to supplement our overall liquidity position, we entered into a 5-year senior secured syndicated credit facility to provide up to $125.0 million in additional capital resources. As of June 30, 2012, no amounts have been drawn against this facility.
 
 
Below is our cash flow activity for the six months ended June 30, 2012 and 2011:
 
 
 
Six Months Ended June 30,
 
 
 
2012
 
 
2011
 
 
 
(in thousands)
 
Consolidated Statements of Cash Flows Data:
 
 
 
 
 
 
Purchases of property and equipment
 
$
17,193
 
 
$
9,064
 
Capitalization of software and website development costs
 
 
5,873
 
 
 
5,044
 
Depreciation and amortization
 
 
21,844
 
 
 
14,992
 
Cash flows used in operating activities
 
 
(38,622
)
 
 
(58,014
)
Cash flows used in investing activities
 
 
(46,461
)
 
 
(148,124
)
Cash flows provided by financing activities
 
 
23,251
 
 
 
29,829
 

We anticipate that our current cash and cash equivalents balances and cash generated from operations will be sufficient to meet our strategic and working capital requirements, lease obligations, and technology development projects for at least the next twelve months. Whether these resources are adequate to meet our liquidity needs beyond that period will depend on our growth, operating results and the capital expenditures required to meet possible increased demand for our products. If we require additional capital resources to grow our business internally or to acquire complementary technologies and businesses at any time in the future, we may seek to sell additional debt or equity. The sale of additional equity could result in additional dilution to our stockholders. Financing arrangements may not be available to us, or may not be in amounts or on terms acceptable to us.

We anticipate that total 2012 capital expenditures will range from 9.7% to 10.2% of our expected net revenues in 2012.  These expenditures will be used to purchase technology and equipment to support the growth in our business and to increase our production capacity and help enable us to respond more quickly and efficiently to customer demand. These expenditures will also be used to purchase additional storage and computer infrastructure to support the migration of Kodak Gallery’s customer accounts and images. An increasing component of these expenditures includes costs associated with capitalized software and website development, as we continue to support our innovative engineering and product development strategies. This range of capital expenditures is not outside the ordinary course of our business or materially different from how we have expanded our business in the past.

The following table shows total capital expenditures by category for the six months ended June 30, 2012 and 2011:

 
 
Six Months Ended
June 30,
 
 
 
2012
 
 
2011
 
    (in thousands)  
Technology equipment and software
 
$
13,720
 
 
$
5,665
 
Percentage of total capital expenditures
 
 
56
%
 
 
40
%
Manufacturing equipment and building improvements
 
 
5,043
 
 
 
3,591
 
Percentage of total capital expenditures
 
 
20
%
 
 
25
%
Capitalized technology and development costs
 
 
5,873
 
 
 
5,045
 
Percentage of total capital expenditures
 
 
24
%
 
 
35
%
Total Capital Expenditures
 
$
24,636
 
 
$
14,301
 
Total Capital Expenditures percentage of net revenues
 
 
13
%
 
 
11
%

Operating Activities. For the six months ended June 30, 2012, net cash used in operating activities was $38.6 million, primarily due to our net loss of $19.6 million and the net change in operating assets and liabilities of $56.7 million largely due to payments of fiscal 2011 year-end obligations.  Net cash used in operating activities was adjusted for non-cash items including $19.1 million of stock-based compensation, $12.7 million of depreciation and amortization expense and $9.1 million of amortization of intangible assets.

For the six months ended June 30, 2011, net cash used in operating activities was $58.0 million, primarily due to our net loss of $11.4 million and the net change in operating assets and liabilities of $78.9 million largely due to payments of fiscal 2010 year-end obligations.  Net cash used in operating activities was adjusted for non-cash items including $10.8 million of depreciation and amortization expense and $17.3 million of stock-based compensation. Another non-cash item included in operating activities is $4.2 million of amortization of intangible assets.

Investing Activities. For the six months ended June 30, 2012, net cash used in investing activities was $46.5 million.  We used $19.6 million in the acquisition of Kodak Gallery's customer accounts and images and $4.5 million in the acquisition of Photoccino Ltd, net of cash acquired. We used $17.2 million for capital expenditures for computer and network hardware to support our website infrastructure and information technology systems, capital expenditures for production equipment for our manufacturing and production operations, and $5.9 million of capitalized software and website development.  Additionally, we received proceeds of $0.7 million from the sale of equipment.

For the six months ended June 30, 2011, net cash used in investing activities was $148.1 million. We used $146.5 million in the acquisition of Tiny Prints net of cash acquired, $9.1 million for capital expenditures for computer and network hardware to support our website infrastructure and information technology systems, capital expenditures for production equipment for our manufacturing and production operations, and $5.0 million of capitalized software and website development.
 

Financing Activities. For the six months ended June 30, 2012, net cash provided by financing activities was $23.3 million, primarily from $7.1 million of proceeds from issuance of common stock from the exercise of options and $16.1 million from excess tax benefit from stock-based compensation.

For the six months ended June 30, 2011, net cash provided by financing activities was $29.8 million, primarily from $18.2 million of proceeds from issuance of common stock from the exercise of options and $11.6 million from excess tax benefits from stock-based compensation.

Non-GAAP Financial Measures

Regulation G, conditions for use of Non-Generally Accepted Accounting Principles ("Non-GAAP") financial measures, and other SEC regulations define and prescribe the conditions for use of certain Non-GAAP financial information. We closely monitor two financial measures, adjusted EBITDA and free cash flow which meet the definition of Non-GAAP financial measures. We define adjusted EBITDA as earnings before interest, taxes, depreciation, amortization, and stock-based compensation.  Free cash flow is defined as adjusted EBITDA less purchases of property and equipment and capitalization of software and website development costs.  Management believes these Non-GAAP financial measures reflect an additional way of viewing our profitability and liquidity that, when viewed with our GAAP results, provides a more complete understanding of factors and trends affecting our earnings and cash flows.  Refer below for a reconciliation of both adjusted EBITDA and free cash flow to the most comparable GAAP measure.

 To supplement our consolidated financial statements presented on a GAAP basis, we believe that these Non-GAAP measures provide useful information about our core operating results and thus are appropriate to enhance the overall understanding of our past financial performance and our prospects for the future. These adjustments to our GAAP results are made with the intent of providing both management and investors a more complete understanding of our underlying operational results and trends and performance. Management uses these Non-GAAP measures to evaluate our financial results, develop budgets, manage expenditures, and determine employee compensation. The presentation of additional information is not meant to be considered in isolation or as a substitute for or superior to net income (loss) or net income (loss) per share determined in accordance with GAAP. Management strongly encourages shareholders to review our financial statements and publicly-filed reports in their entirety and not to rely on any single financial measure.

The table below shows the trend of adjusted EBITDA and free cash flow as a percentage of net revenues for the three and six months ended June 30, 2012 and 2011 (in thousands):
 
    Three Months Ended     Six Months Ended  
    June 30,     June 30,  
    2012     2011     2012     2011  
Net revenues
  $ 99,020     $ 75,764     $ 190,311     $ 132,993  
                                 
Non-GAAP Adjusted EBITDA
  $ 3,560     $ (282 )   $ 4,121     $ (2,200 )
EBITDA % of Net revenues
    4 %     0 %     2 %     (2 )%
                                 
Free cash flow
  $ (11,505 )   $ (6,819 )   $ (20,515 )   $ (16,501 )
Free cash flow % of Net revenues
    (12 )%     (9 )%     (11 )%     (12 )%

By carefully managing our operating costs and capital expenditures, we were able to make the strategic investments we believe are necessary to grow and strengthen our business.  For the three and six months ended June 30, 2012, our adjusted EBITDA was $3.6 million and $4.1 million, respectively, as compared to ($0.3) million and ($2.2) million in the same periods in 2011. 
 
During the three and six months ended June 30, 2012, we experienced negative free cash flows of $11.5 million and $20.5 million, respectively. However, during the fiscal year, we take steps designed to preserve the opportunity to achieve full year positive free cash flows.
 
Free cash flow has limitations due to the fact that it does not represent the residual cash flow for discretionary expenditures.  For example, free cash flow does not incorporate payments made on capital lease obligations or cash requirements to comply with debt covenants.  Therefore, we believe that it is important to view free cash flow as a complement to our reported consolidated financial statements.
 

The following is a reconciliation of adjusted EBITDA and free cash flow to the most comparable GAAP measure, for the three and six months ended June 30, 2012 and 2011 (in thousands):
 
  Reconciliation of Net Loss to Non-GAAP Adjusted EBITDA
 
Three Months Ended
 
 
Six Months Ended
 
 
 
June 30,
 
 
June 30,
 
 
 
2012
 
 
2011
 
 
2012
 
 
2011
 
Net loss
 
$
(9,511
)
 
$
(3,650
)
 
$
(19,551
)
 
$
(11,410
)
Add back:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Interest expense
 
 
156
 
 
 
-
 
 
 
308
 
 
 
-
 
Interest and other income, net
 
 
(9
)
 
 
(6
)
 
 
(16
)
 
 
(20
)
Tax benefit
 
 
(8,422
)
 
 
(17,884
)
 
 
(17,607
)
 
 
(23,096
)