Document
 
UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, DC 20549
Form 10-Q
(Mark One)
ý
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended March 31, 2018
 
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

Securities registered pursuant to Section 12(b) of the Act:

Title of Each Class
 
Name of Each Exchange on Which Registered
Common Stock, $0.0001 Par Value Per Share
 
The Nasdaq Global Select Market

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   ý       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 ý      No o

Indicate by check mark whether the Registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company, or an emerging growth 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
 
Emerging growth company o
(Do not check if a smaller reporting company)


1


If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. o 

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

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.
Class
 
Outstanding as of May 7, 2018
Common stock, $0.0001 par value per share
 
33,160,496
 

2


TABLE OF CONTENTS

 
Page
Number
Part I - Financial Information
 
 
Part II - Other Information
 







3

Table of Contents

PART IFINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

SHUTTERFLY, INC.
CONDENSED CONSOLIDATED BALANCE SHEETS
(In thousands, except par value amounts)
(Unaudited)
 
 
March 31, 2018
 
December 31, 2017
ASSETS
 
 
 
Current assets:
 
 
 
Cash and cash equivalents
$
419,371

 
$
489,894

Short-term investments
120,107

 
178,021

Accounts receivable, net
54,142

 
82,317

Inventories
10,150

 
11,019

Prepaid expenses and other current assets
56,351

 
41,383

Total current assets
660,121

 
802,634

Long-term investments
4,941

 
9,242

Property and equipment, net
259,951

 
266,860

Intangible assets, net
27,618

 
29,671

Goodwill
408,975

 
408,975

Other assets
17,622

 
17,418

Total assets
$
1,379,228

 
$
1,534,800

LIABILITIES AND STOCKHOLDERS’ EQUITY
 
 
 
Current liabilities:
 
 
 
Current portion of long-term debt
$
301,004

 
$
297,054

Accounts payable
17,210

 
91,473

Accrued liabilities
76,881

 
159,248

Deferred revenue
22,049

 
24,649

Total current liabilities
417,144

 
572,424

Long-term debt
291,879

 
292,457

Other liabilities
114,607

 
119,195

Total liabilities
823,630

 
984,076

Commitments and contingencies (Note 10)

 

Stockholders’ equity:
 
 
 
Common stock, $0.0001 par value; 100,000 shares authorized; 33,122 and 32,297 shares issued and outstanding on March 31, 2018 and December 31, 2017, respectively
3

 
3

Additional paid-in capital
1,022,091

 
996,301

Accumulated other comprehensive income
3,826

 
1,778

Accumulated deficit
(470,322
)
 
(447,358
)
Total stockholders' equity
555,598

 
550,724

Total liabilities and stockholders' equity
$
1,379,228

 
$
1,534,800

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

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Table of Contents

SHUTTERFLY, INC.
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(In thousands, except per share amounts)
(Unaudited)


Three Months Ended

March 31,
 
2018
 
2017
Net revenues
$
199,725

 
$
191,972

Cost of net revenues
126,046

 
116,119

Restructuring

 
1,240

Gross profit
73,679

 
74,613

Operating expenses:
 
 
 

Technology and development
38,504

 
45,955

Sales and marketing
37,720

 
42,887

General and administrative
31,565

 
27,795

Restructuring

 
7,736

Total operating expenses
107,789

 
124,373

Loss from operations
(34,110
)
 
(49,760
)
Interest expense
(9,633
)
 
(5,964
)
Interest and other income, net
1,749

 
189

Loss before income taxes
(41,994
)
 
(55,535
)
Benefit from income taxes
14,829

 
22,341

Net loss
$
(27,165
)
 
$
(33,194
)
 
 
 
 
Net loss per share - basic and diluted
$
(0.83
)
 
$
(0.98
)
 
 
 
 
Weighted-average shares outstanding - basic and diluted
32,702

 
33,712

 
 
 
 
Stock-based compensation is allocated as follows (Note 3):
 
 
 
Cost of net revenues
$
999

 
$
1,169

Technology and development
2,429

 
2,696

Sales and marketing
3,504

 
3,173

General and administrative
4,760

 
4,467

Restructuring

 
814

 
$
11,692

 
$
12,319


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

5

Table of Contents

SHUTTERFLY, INC.
CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS)
(In thousands)
(Unaudited)

 
Three Months Ended
 
March 31,
 
2018
 
2017
Net loss
$
(27,165
)
 
$
(33,194
)
Other comprehensive income (loss), net of reclassification adjustments:
 
 
 
Unrealized losses on investments, net
(30
)
 
(13
)
Tax benefit on unrealized losses on investments, net
7

 
10

Unrealized gains on cash flow hedges
2,770

 

Tax expense on unrealized gains on cash flow hedges
(699
)
 

Other comprehensive income (loss), net of tax
2,048

 
(3
)
Comprehensive loss
$
(25,117
)
 
$
(33,197
)

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


6

Table of Contents

SHUTTERFLY, INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands)
(Unaudited)

 
Three Months Ended
 
March 31,
 
2018
 
2017
Cash flows from operating activities:
 
 
 
Net loss
$
(27,165
)
 
$
(33,194
)
Adjustments to reconcile net loss to net cash used in operating activities:
 

 
 

Depreciation and amortization
22,564

 
23,024

Amortization of intangible assets
2,334

 
4,340

Amortization of debt discount and issuance costs
4,122

 
3,735

Stock-based compensation
11,692

 
11,505

Loss on disposal of property and equipment
225

 
172

Deferred income taxes
4,264

 
2,358

Restructuring

 
7,868

Changes in operating assets and liabilities:
 

 
 

Accounts receivable
28,174

 
24,122

Inventories
869

 
847

Prepaid expenses and other assets
(15,642
)
 
(11,577
)
Accounts payable
(73,773
)
 
(44,655
)
Accrued and other liabilities
(81,996
)
 
(60,931
)
Net cash used in operating activities
(124,332
)
 
(72,386
)
Cash flows from investing activities:
 

 
 

Purchases of property and equipment
(8,075
)
 
(3,517
)
Capitalization of software and website development costs
(8,584
)
 
(7,602
)
Purchases of investments
(9,523
)
 
(26,304
)
Proceeds from the maturities of investments
72,068

 
6,214

Proceeds from sale of property and equipment
649

 
70

Net cash provided by (used in) investing activities
46,535

 
(31,139
)
Cash flows from financing activities:
 

 
 

Proceeds from issuance of common stock upon exercise of stock options
13,775

 
117

Repurchases of common stock

 
(20,000
)
Principal payments of capital lease and financing obligations
(4,643
)
 
(4,301
)
Principal payments of borrowings
(750
)
 

Payment of debt issuance costs
(1,108
)
 

Net cash provided by (used in) financing activities
7,274

 
(24,184
)
Net decrease in cash and cash equivalents
(70,523
)
 
(127,709
)
Cash and cash equivalents, beginning of period
489,894

 
289,224

Cash and cash equivalents, end of period
$
419,371

 
$
161,515

 
 
 
 
Supplemental schedule of non-cash investing / financing activities:
 
 
 

Net decrease in accrued purchases of property and equipment
$
(3,780
)
 
$
(1,848
)
Net increase in accrued capitalized software and website development costs
357

 
124

Stock-based compensation capitalized with software and website development costs
323

 
258

Property and equipment acquired under capital leases
2,969

 


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

7

Table of Contents

SHUTTERFLY, INC.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

Note 1 — The Company and Summary of Significant Accounting Policies

Shutterfly, Inc., (the “Company” or "Shutterfly") is the leading digital retailer and manufacturer of high-quality personalized products and services. Founded and incorporated in the state of Delaware in 1999, Shutterfly brings your photos to life in photo books, gifts, and cards and stationery - through its flagship Shutterfly products, premium offerings in its Tiny Prints boutique, as well as wedding invitations and stationery for every step of the wedding planning process; BorrowLenses, the premier online marketplace for photographic and video equipment rentals; and Groovebook, an iOS and Android app and subscription service that prints up to 100 mobile device photos in a Groovebook and mails it to customers every month. Shutterfly, Inc. also operates Shutterfly Business Solutions (“SBS”), delivering high quality digital printing services to the enterprise market. 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 ("U.S. GAAP") for interim financial information and, accordingly, do not include all of the information and footnotes required by U.S. GAAP 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 months ended March 31, 2018 are not necessarily indicative of the results that may be expected for the year ending December 31, 2018, or for any other period.

The December 31, 2017 condensed consolidated balance sheet data was derived from audited financial statements, but does not include all disclosures required by U.S. GAAP. 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, 2017 included in the Company’s Annual Report on Form 10-K.

Recently Adopted Accounting Pronouncements
    
In 2014, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) 2014-09, Revenue from Contracts with Customers (Topic 606) (“ASC 606”). This new standard replaces all current GAAP guidance on this topic and eliminates all industry-specific guidance. The new revenue recognition guidance provides a unified model to determine when and how revenue is recognized. The core principle is that a company should recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration for which the entity expects to be entitled in exchange of those goods or services. The Company adopted ASC 606 as of January 1, 2018 using the modified retrospective transition method. Refer to Note 2 - Revenues for further details.

In August 2016, the FASB issued ASU 2016-15, Classification of Certain Cash Receipts and Cash Payments. The Company adopted ASU 2016-15 as of January 1, 2018 on a retrospective basis with no material impact to the consolidated statements of cash flows for the three months ended March 31, 2018 and 2017.

Recent Accounting Pronouncements Pending Adoption
    
In February 2018, the FASB issued ASU No. 2018-02, Income Statement, Reporting Comprehensive Income (Topic 220): Reclassification of Certain Effects from Accumulated Other Comprehensive Income (“ASU 2018-02”), which allows a reclassification of stranded tax effects from accumulated other comprehensive income to retained earnings, as a result of the Tax Cuts and Jobs Act (“Tax Act”). ASU 2018-02 is effective for fiscal years, and interim periods within those years, beginning after December 15, 2018, with early adoption permitted and can be applied either in the period of adoption or retrospectively to all applicable periods. The Company does not expect that the pending adoption of ASU 2018-02 will have a material impact on the consolidated financial statements.
    
In February 2016, the FASB issued ASU 2016-02, Leases (Topic 842). The new guidance requires the recognition of lease assets and lease liabilities by lessees for those leases classified as operating leases under previous guidance. The new standard is effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2018 on a modified retrospective basis, and earlier adoption is permitted. The Company is evaluating the impact of adopting this new accounting guidance on the consolidated financial statements.

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Table of Contents
SHUTTERFLY, INC.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

    
In June 2016, the FASB issued ASU 2016-13, Financial Instruments-Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments, which requires measurement and recognition of expected credit losses for financial assets held. The new standard is effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2019. Earlier adoption is permitted for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2018. The Company is evaluating the impact of adopting this new accounting guidance on the consolidated financial statements.

In January 2017, the FASB issued ASU 2017-04, Intangibles - Goodwill and Other (Topic 350). The updated guidance simplifies the measurement of goodwill impairment by removing step two of the goodwill impairment test, which requires the determination of the fair value of individual assets and liabilities of a reporting unit. The new guidance requires goodwill impairment to be measured as the amount by which a reporting unit’s carrying value exceeds its fair value; however, the loss recognized should not exceed the total amount of goodwill allocated to that reporting unit. The amendments should be applied on a prospective basis. The new standard is effective for annual or any interim goodwill impairment tests performed in fiscal years beginning after December 15, 2019 with early adoption permitted for interim or annual goodwill impairment tests performed on testing dates after January 1, 2017. The Company is evaluating the impact this new accounting guidance will have on the consolidated financial statements.

Note 2 — Revenues

Adoption of ASC 606, Revenue from Contracts with Customers

The Company adopted ASC 606 as of January 1, 2018 using the modified retrospective transition method. Under the modified retrospective method, ASC 606 is only applied to contracts that were not complete as of the adoption date. Results for reporting periods beginning after January 1, 2018 are presented under ASC 606, while prior period amounts are not adjusted and continue to be reported in accordance with our historic accounting under ASC 605.

As a result of the adoption of ASC 606, the Company identified an impact related to timing and measurement of breakage revenue for the consumer business and for one of the Company's significant multiple-element arrangements in connection with the SBS business. Upon adoption of ASC 606, the Company recognizes the expected breakage amounts as revenue in proportion to the pattern of rights exercised by the customer, rather than the previous method of recognizing breakage revenue when the Company believed the redemption was remote. As it relates to timing and measurement of one of the Company's multiple-element arrangements in connection with the SBS business, deferred revenue was previously recognized over the stated term of the contract. Upon adoption of ASC 606, deferred revenue for this particular arrangement is now recognized ratably over a period of time that is shorter than the stated contract term, as this arrangement does not contain substantive termination penalties after a certain initial number of years within the contractual term. 

The cumulative impact of the adoption of ASC 606 resulted in a decrease to opening accumulated deficit of $4.2 million as of January 1, 2018 which consisted of a decrease in total liabilities of $5.1 million primarily related to deferred revenue and a decrease in total assets of $0.9 million primarily related to deferred costs.

The impact as a result of applying ASC 606 was an increase of $0.5 million to revenues for the three months ended March 31, 2018 and a decrease to deferred revenue of $6.8 million and deferred costs of $0.7 million as of March 31, 2018. The impact to other accounts is not significant as of March 31, 2018 and for the three months ended March 31, 2018.

Revenue Recognition Policy

The Company derives its revenues primarily from Consumer and SBS product sales, net of applicable sales tax and allowances for returns. Revenues are recognized when control of the promised products or services is transferred to its customers in an amount that reflects the consideration it expects to be entitled to in exchange for those products or services. Shipping charged to its customers is recognized upon shipment and the related shipping costs are recognized as cost of net revenues.

Consumer. The Company’s Consumer revenues are primarily derived from the sale of products such as, professionally-bound photo books, cards and stationery, custom home décor products and unique photo gifts, calendars and prints, etc. Customers place Consumer product orders through the Company’s website or mobile apps and pay primarily using credit cards. The credit card payments are charged, and revenue is recognized upon shipment of the fulfilled orders, which generally occurs upon delivering to the carrier. If multiple products are ordered together, each product is a separate performance obligation, and the transaction price is allocated to each performance obligation based upon standalone selling price as each performance obligation is satisfied.

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Table of Contents
SHUTTERFLY, INC.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

The Company generally determines the standalone selling prices based on the prices charged to its customers or using expected cost plus margin.

For flash deal promotions through group buying websites, the Company recognizes revenue on a gross basis, as it is the primary obligor, when redeemed items are shipped. Revenues from sales of flash deal promotions are deferred until shipment of fulfilled orders or until unredeemed flash deal promotions are recognized as breakage revenue. The Company recognizes the expected breakage amounts as revenue in proportion to the pattern of rights exercised by the customer.

The Company periodically provides incentive offers to its new customers in exchange for setting up an account as well as to its existing customers to encourage purchases. These incentive offers are readily available to all of its customers. Therefore, these do not represent a performance obligation as its customers are not required to enter into any enforceable commitment by receiving these incentive offers. The discounts are treated as a price reduction when accepted and used by customers. Production costs related to free products are included in cost of revenues upon redemption.

SBS. The Company’s SBS revenues are derived from personalized direct marketing and other end-consumer communications as well as just-in-time, inventory-free printing for its business customers. The services that the Company promises to its SBS customers are typically composed of a series of services that are performed over time. The Company accounts for these series of services as one performance obligation which represents a series of distinct services that are substantially the same and have the same pattern of transfer.

The Company recognizes revenues from the satisfaction of performance obligations when it invoices its customers (that is, when it has the contractual right to bill under the contract). The Company has the contractual right to consideration from its customers in an amount that corresponds directly with the value to the customer of the services it has performed to date. For contracts that do not contain a significant non-refundable up-front fee, the Company applies the “right to invoice” practical expedient as it has the right to consideration from its customers in an amount that corresponds directly with the value to the customer of the services it has performed to date. For contracts that contain a significant non-refundable up-front fee, the Company considers whether these fees are related to the transfer of a promised good or service to the customer, and therefore represent a performance obligation. When the up-front fees do not represent a distinct performance obligation, the Company recognizes revenue ratably over the period for which there is a significant termination contractual penalty.

The Company's incremental direct costs of obtaining a contract consist of SBS sales commissions. The Company does not defer such incremental direct costs as the related performance obligations are satisfied within a short period of time and the Company elected to apply the practical expedient per ASC 340-40-25-4 related to expensing contract acquisition costs with the amortization period of less than one year. The Company does not provide any financing service to its customer as payment term.

Deferred Revenues

The Company records deferred revenue when cash payments are received in advance of our performance and primarily relate to flash deal promotions and gift cards as well as up-front fees received from an SBS customer. The decrease of $7.9 million in deferred revenue balance during the three months ended March 31, 2018 is primarily driven by the aforementioned impact of ASC 606 adoption and $2.4 million of revenues recognized that were included in deferred revenue balance as of December 31, 2017, offset by cash payments received in advance of our performance obligations during the three months ended March 31, 2018.

The remaining deferred revenue balance for the aforementioned up-front fees received from an SBS customer during a previous year is $3.6 million and it will be recognized primarily within the next 12 months.

Revenues by Brand

The following table disaggregates the Company’s revenue by brand for the three months ended March 31, 2018 and 2017:


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Table of Contents
SHUTTERFLY, INC.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

 
Three Months Ended
 
March 31,
 
2018
 
2017
 
(in thousands)
Consumer net revenues:
 
 
 
Shutterfly brand
$
142,664

 
$
123,903

Tiny Prints Boutique[1]
2,103

 

Tiny Prints[1]

 
10,465

Wedding Paper Divas[2]

 
14,290

MyPublisher[3]

 
4,936

Other
7,292

 
7,051

Total Consumer net revenues
152,059

 
160,645

Total Shutterfly Business Solutions net revenues
47,666

 
31,327

Total net revenues
$
199,725

 
$
191,972

 
 
 
 
[1] On June 28, 2017, the Company created a Tiny Prints boutique on a dedicated tab on Shutterfly.com and shut down the legacy Tiny Prints website.
[2] On September 13, 2017, the Company launched the new Shutterfly Wedding Shop and shut down the Wedding Paper Divas legacy website.
[3] The MyPublisher brand was retired on May 15, 2017.


Note 3 — Stock-Based Compensation

Stock Option Activity

A summary of the Company’s stock option activity for the three months ended March 31, 2018 is as follows (share numbers and aggregate intrinsic values in thousands):
 
Number of
Options
Outstanding
 
Weighted
Average
Exercise
Price
 
Weighted
Average Remaining
Contractual
Term (Years)
 
Aggregate
Intrinsic
Value
Balance as of December 31, 2017
1,529

 
$
46.77

 
 
 
 
Granted
228

 
76.73

 
 
 
 
Exercised
(299
)
 
46.15

 
 
 
 
Forfeited, cancelled or expired
(2
)
 
53.77

 
 
 
 
Balance as of March 31, 2018
1,456

 
$
51.58

 
5.6
 
$
43,219

Options vested and expected to vest as of March 31, 2018
1,331

 
$
50.99

 
5.5
 
$
40,269

Options vested as of March 31, 2018
277

 
$
46.48

 
4.9
 
$
9,645

 
During the three months ended March 31, 2018, the Company granted options to purchase an aggregate of approximately 228,000 shares of common stock with an estimated weighted-average grant-date fair value of $23.57. The total intrinsic value of options exercised during the three months ended March 31, 2018 and 2017 was $7.9 million and $0.1 million, respectively. Net cash proceeds from the exercise of stock options for the three months ended March 31, 2018 and 2017 were $13.8 million and $0.1 million, respectively.

Valuation of Stock Options

The Company estimates the fair value of each option award on the date of grant using the Black-Scholes option-pricing model. The Company calculates volatility using an average of its historical and implied volatilities as it has sufficient public trading history

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Table of Contents
SHUTTERFLY, INC.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

to cover the entire expected term. The expected term of options gives consideration to historical exercises, post-vest 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 months ended March 31, 2018 and 2017 are as follows:
 
Three Months Ended
 
March 31,
 
2018
 
2017
Dividend yield

 

Annual risk-free rate of return
2.6
%
 
2.0
%
Expected volatility
33.7
%
 
29.7
%
Expected term (years)
4.1

 
4.1


Restricted Stock Unit Activity

The Company grants restricted stock units (“RSUs”) and performance-based restricted stock units ("PBRSUs") to its employees under the provisions of the 2015 Equity Incentive Plan and inducement awards to certain new employees upon hire in accordance with NASDAQ Listing Rule 5635(c)(4). 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 are settled annually, based on a four-year total vesting term. Compensation cost associated with RSUs is amortized on a straight-line basis over the requisite service period.

A summary of the Company’s RSU activity for the three months ended March 31, 2018, is as follows (share numbers in thousands):
 
Number of
Units
Outstanding
 
Weighted
Average
Grant Date
Fair Value
Awarded and unvested as of December 31, 2017
2,293

 
$
44.64

Granted
554

 
75.42

Vested
(525
)
 
44.04

Forfeited
(35
)
 
45.27

Awarded and unvested as of March 31, 2018
2,287

 
$
52.22

RSUs expected to vest as of March 31, 2018
1,905

 
 

Employee stock-based compensation expense recognized in the three months ended March 31, 2018 and 2017 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.

At March 31, 2018, the Company had $94.1 million of total unrecognized stock-based compensation expense, net of estimated forfeitures, related to stock options, RSUs and PBRSUs that will be recognized over a weighted-average period of approximately two years.

Note 4 — Net Loss Per Share

Basic 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 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 RSUs and incremental shares of common stock issuable upon the exercise of stock options, conversion of warrants, and the impact of convertible senior notes.

A summary of the net loss per share for the three months ended March 31, 2018 and 2017 is as follows (in thousands, except per share amounts):

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Table of Contents
SHUTTERFLY, INC.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

 
Three Months Ended
 
March 31,
 
2018
 
2017
Net loss per share:
 
 
 
Numerator
 
 
 
Net loss
$
(27,165
)
 
$
(33,194
)
Denominator for basic and diluted net loss per share
 

 
 
Weighted-average common shares outstanding
32,702

 
33,712

Net loss per share - basic and diluted
$
(0.83
)
 
$
(0.98
)

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
 
March 31,
 
2018
 
2017
Stock options and restricted stock units
3,687

 
3,961


With respect to the convertible senior notes issued in 2013 as described in Note 8 - Debt, the Company has determined that it has the ability and intent to settle the principal of the convertible senior notes in cash. The Company intends to settle the conversion spread, excess conversion value over the principal, in stock which is approximately 373,000 shares as of March 31, 2018. The potential conversion impact was excluded from the computation of diluted net loss per common share for the current quarter presented because including it would have had an anti-dilutive effect.

Note 5 — Investments

At March 31, 2018 and December 31, 2017, the estimated fair value of short-term and long-term investments classified as available-for-sale were as follows (in thousands):
 
 
March 31, 2018
 
 
Amortized Cost
 
Gross Unrealized Gains
 
Gross Unrealized Losses
 
Estimated Fair Value
Short-term investments
 
 
 
 
 
 
 
 
Corporate debt securities
 
$
43,723

 
$

 
$
(73
)
 
$
43,650

Agency securities
 
9,927

 

 
(20
)
 
9,907

Commercial paper
 
55,191

 

 

 
55,191

U.S. Government securities
 
11,371

 

 
(12
)
 
11,359

Total short-term investments
 
$
120,212

 
$

 
$
(105
)
 
$
120,107

Long-term investments
 
 
 
 
 
 
 
 
Corporate debt securities
 
$
3,114

 
$

 
$
(24
)
 
$
3,090

Agency securities
 
1,370

 

 
(15
)
 
1,355

U.S. Government securities
 
499

 

 
(3
)
 
496

Total long-term investments
 
$
4,983

 
$

 
$
(42
)
 
$
4,941



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SHUTTERFLY, INC.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

 
 
December 31, 2017
 
 
Amortized Cost
 
Gross Unrealized Gains
 
Gross Unrealized Losses
 
Estimated Fair Value
Short-term investments
 
 
 
 
 
 
 
 
Corporate debt securities
 
$
54,911

 
$
3

 
$
(52
)
 
$
54,862

Agency securities
 
10,781

 

 
(14
)
 
10,767

Commercial paper
 
101,546

 

 

 
101,546

U.S. Government securities
 
10,857

 

 
(11
)
 
10,846

Total short-term investments
 
$
178,095

 
$
3

 
$
(77
)
 
$
178,021

Long-term investments
 
 
 
 
 
 
 
 
Corporate debt securities
 
$
6,287

 
$

 
$
(25
)
 
$
6,262

Agency securities
 
2,000

 

 
(17
)
 
1,983

U.S. Government securities
 
998

 

 
(1
)
 
997

Total long-term investments
 
$
9,285

 
$

 
$
(43
)
 
$
9,242


The Company had no available-for-sale investments with a significant unrealized loss that have been in a continuous unrealized loss position for more than 12 months as of March 31, 2018, and no impairments were recorded during the three months ended March 31, 2018 and 2017. The Company had no material realized gains or losses during the three months ended March 31, 2018 and 2017.

The following table summarizes the contractual maturities of the Company's investments as of March 31, 2018 and December 31, 2017 (in thousands):
 
March 31, 2018
 
December 31, 2017
One year or less
$
120,107

 
$
178,021

One year through three years
4,941

 
9,242

 
$
125,048

 
$
187,263


Actual maturities may differ from the contractual maturities because borrowers may have certain prepayment conditions.

Note 6 — Fair Value Measurement

Cash Equivalents and Investments

The Company measures the fair value of money market funds and investments based on quoted prices in active markets for identical assets or liabilities. All other financial instruments were valued either based on recent trades of securities in inactive markets or based on quoted market prices of similar instruments and other significant inputs derived from or corroborated by observable market data. The Company did not hold any cash equivalents or investments categorized as Level 3 as of March 31, 2018 and December 31, 2017.

The following table summarizes, by major security type, the Company's cash equivalents and investments that are measured at fair value on a recurring basis and are categorized using the fair value hierarchy (in thousands):

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SHUTTERFLY, INC.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

 
Total Estimated Fair Value as of
 
March 31, 2018
 
December 31, 2017
 
Cash Equivalents
 
Investments
 
Cash Equivalents
 
Investments
Level 1 Securities:
 
 
 
 
 
 
 
Money market funds
$
150,008

 
$

 
$
151,071

 
$

Level 2 Securities:
 
 
 
 
 
 
 
Corporate debt securities
525

 
46,740

 
21,592

 
61,124

Agency securities

 
11,262

 
6,444

 
12,750

Commercial Paper
7,847

 
55,191

 
85,599

 
101,546

U.S. Government securities

 
11,855

 

 
11,843

Total cash equivalents and investments
$
158,380

 
$
125,048

 
$
264,706

 
$
187,263


Derivative Assets

As of March 31, 2018 and December 31, 2017, the fair value of the interest-rate swap agreements, which were determined based on an income-based valuation model that takes into account the contract terms as well as multiple observable market inputs such as LIBOR-based yield curves, futures, volatilities and basis spreads (Level 2), were as follows (in thousands):
 
Total Estimated Fair Value as of
 
March 31, 2018
 
December 31, 2017
Derivative assets
$
5,749

 
$
2,979


Borrowings

As of March 31, 2018 and December 31, 2017, the fair value of the Company's borrowings, which was determined based on inputs that are observable in the market or that could be derived from, or corroborated with, observable market data, including the Company's stock price, interest rates and credit spread (Level 2) were as follows (in thousands):
 
Total Estimated Fair Value as of
 
March 31, 2018
 
December 31, 2017
Convertible senior notes
$
278,742

 
$
296,550

Term Loan
301,875

 
300,000


As of March 31, 2018 and December 31, 2017, the carrying value of other financial instruments, including accounts receivable, accounts payable and other payables, approximates fair value due to their short maturities.

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SHUTTERFLY, INC.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

Note 7 — Balance Sheet Components

Prepaid Expenses and Other Current Assets
 
March 31, 2018
 
December 31, 2017
 
(in thousands)
Intra-period deferred tax asset
$
19,099

 
$

Prepaid service contracts – current portion
14,364

 
12,861

Prepaid postage
5,860

 
3,274

Manufacturing partners receivable
1,188

 
6,322

Other prepaid expenses and current assets
15,840

 
18,926

 
$
56,351

 
$
41,383


Intra-period income 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.

Property and Equipment, Net
 
March 31, 2018
 
December 31, 2017
 
(in thousands)
Manufacturing equipment
$
195,116

 
$
192,494

Computer equipment and software
164,298

 
188,593

Capitalized software and website development costs
139,959

 
134,585

Buildings under build-to-suit leases
56,468

 
56,468

Leasehold improvements
24,601

 
22,145

Rental equipment
18,533

 
19,208

Furniture and fixtures
7,788

 
8,255

 
606,763

 
621,748

Less: Accumulated depreciation and amortization
(346,812
)
 
(354,888
)
Property and equipment, net
$
259,951

 
$
266,860

 
Included within manufacturing equipment is approximately $92.9 million and $89.9 million of capital lease obligations for various pieces of manufacturing facility equipment as of March 31, 2018 and December 31, 2017, respectively. Accumulated depreciation of assets under capital leases totaled $36.2 million and $32.4 million at March 31, 2018 and December 31, 2017, respectively.

Rental equipment includes camera lenses, camera bodies, video equipment and other camera peripherals which are rented through the BorrowLenses website.

Depreciation and amortization expense totaled $22.6 million and 23.0 million for the three months ended March 31, 2018 and 2017, respectively.

Included in property and equipment is approximately $11.2 million and $15.8 million of assets in construction as of March 31, 2018 and December 31, 2017, respectively, the majority of which relates to capitalized software and website development costs.


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SHUTTERFLY, INC.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

Accrued Liabilities
 
March 31, 2018
 
December 31, 2017
 
(in thousands)
Accrued compensation
$
19,679

 
$
31,331

Capital lease obligations, current portion
17,019

 
16,859

Accrued production costs
11,591

 
37,552

Accrued marketing expenses
7,769

 
22,874

Accrued income, sales and other taxes
3,912

 
21,745

Accrued other
16,911

 
28,887

 
$
76,881

 
$
159,248

 
Other Liabilities
 
March 31, 2018
 
December 31, 2017
 
(in thousands)
Financing obligations
$
53,226

 
$
53,682

Capital lease obligations, non-current portion
47,174

 
48,620

Deferred tax liability
4,302

 
1,012

Other liabilities
9,905

 
15,881

 
$
114,607

 
$
119,195


Financing obligations relate to the Company's build-to-suit leases for the Company's manufacturing facilities in Fort Mill, South Carolina; Shakopee, Minnesota; and Tempe, Arizona.

Note 8 — Debt

2017 Syndicated Credit Facility

On August 17, 2017 (“Closing Date”), the Company entered into a credit agreement (“Credit Agreement”) with certain lenders and Morgan Stanley Senior Funding, Inc., as administrative agent and collateral agent. The Credit Agreement provides for (a) a secured revolving loan facility in an aggregate principal amount of up to $200.0 million (“Revolving Loan Facility”) and (b) a secured delayed draw term loan facility (“Initial Term Loan”) in an aggregate principal amount of up to $300.0 million. The Credit Agreement permits the Company to add one or more incremental term loan facilities and/or increase the commitments for revolving loans subject to certain conditions.

In October 2017, the Company fully drew the $300.0 million Initial Term Loan under the Credit Agreement. The proceeds of the Initial Term Loan will be used (1) to settle the Company's existing 0.25% Convertible Senior Notes due May 15, 2018 and (2) for working capital and general corporate purposes. On April 2, 2018, the Company entered into an amendment under the Credit Agreement for an incremental term loan in an aggregate principal amount of $825.0 million ("Incremental Term Loan") to finance the acquisition of Lifetouch, Inc. The full amount of the $200.0 million Revolving Loan Facility remains undrawn as of March 31, 2018.

Upon funding of the Initial Term Loan, the Company elected to bear interest rate of one-month LIBOR, subject to a floor of 0.0%, plus an applicable margin of 2.50% per annum. The effective interest rate for the unhedged portion of the Initial Term Loan during the three months ended March 31, 2018 was 4.10%. Upon funding of the Incremental Term Loan, the Company elected to bear interest rate of one-month LIBOR, subject to a floor of 0.0%, plus an applicable margin of 2.75% per annum. The applicable margin of 2.75% for the Incremental Term Loan is determined based on a secured leverage ratio as defined by the Incremental Term Loan Amendment dated April 2, 2018.

The revolving loans under the Credit Agreement bear interest, at the election of the Company, at either (a) the base rate (the "Base Rate"), which is defined as a fluctuating rate per annum equal to the greatest of (1) the prime rate then in effect, (2) the federal funds rate then in effect, plus 0.50%, and (3) an adjusted LIBOR rate determined on the basis of a one-month interest

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SHUTTERFLY, INC.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

period, plus 1.0% or (b)  an adjusted LIBOR Rate, subject to a floor of 0.0% (the "LIBOR Rate"), in each case, plus an applicable margin of (1) initially, 0.75% per annum in the case of Base Rate loans and 1.75% per annum in the case of LIBOR Rate loans or (2) following the Company’s delivery of financial statements for the first full fiscal quarter following the Closing Date, 0.50% to 0.75% per annum in the case of Base Rate loans and 1.50% to 1.75% per annum in the case of LIBOR Rate loans, in each case based on the Company’s consolidated secured net leverage ratio, measured as of the end of the most recently ended fiscal quarter. In connection with the Credit Agreement, the Company is also required to pay commitment fees, closing fees, arrangement fees, ticking fees and administration fees, and other customary fees and costs.
Both the Initial Term Loan and the Incremental Term Loan have a maturity date of August 17, 2024. Commencing on the respective last day of the first full fiscal quarter following the Company's respective borrowings of the Initial Term Loan and the Incremental Term Loan, the respective Initial Term loan and Incremental Term Loan will amortize in equal quarterly installments of 0.25% of the original principal for each loan, with the remaining respective principal balances payable on the maturity date. Amounts drawn on the Revolving Loan Facility, if any, mature on August 17, 2022. Further, the Company has the right to prepay its borrowings under the Credit Agreement in whole or in part at any time without a premium or penalty, subject to certain limitations and a 1.0% repricing premium applicable during the first six months for the Initial Term Loan and/or the Incremental Term Loan. The Credit Agreement also contains certain customary mandatory prepayments under certain conditions as set forth in the Credit Agreement.
The Credit Agreement contains customary affirmative and negative covenants, including covenants that limit or restrict the Company’s and its subsidiaries’ ability to, among other things, incur indebtedness, grant liens, undergo certain fundamental changes, dispose of assets, make investments, enter into transactions with affiliates, and make certain restricted payments, in each case subject to limitations and exceptions set forth in the Credit Agreement. The Company is also required to maintain compliance, measured as of the end of each fiscal quarter, with a consolidated secured net leverage ratio and a consolidated interest expense coverage ratio. As of March 31, 2018, the Company is in compliance with these covenants.
In August 2017, the Company entered into certain interest-rate swap agreements with an effective date of October 18, 2017 that have the economic effect of modifying a portion of the variable interest-rate obligations associated with the secured delayed draw Initial Term Loan so that the interest payable on such portion become fixed (refer to Note 13 - Derivative Financial Instruments for further details regarding the interest-rate swap agreements).
The Company incurred $5.6 million in credit facility origination costs during the year ended December 31, 2017 related to the Credit Agreement. The origination costs attributable to the Revolving Loan Facility were capitalized within prepaid expenses for the current portion and other assets for the non-current portion. The origination costs attributable to the Initial Term Loan are presented as a reduction to the carrying value of the debt in the consolidated balance sheet. Fees attributable to the Revolving Loan Facility of $0.8 million are being amortized over five years and fees attributable to the Initial Term Loan of $4.8 million are being amortized over seven years, both as a component of interest expense.
The Initial Term Loan consist of the following (in thousands):

 
March 31, 2018
 
December 31, 2017
Liability component:
 
 
 
Principal borrowing
$
300,000

 
$
300,000

Less: principal payments
(750
)
 

Less: debt issuance costs, net of amortization
(4,371
)
 
(4,543
)
Net carrying amount
$
294,879

 
$
295,457

 
 
 
 
Term loan, current
3,000

 
3,000

Term loan, non-current
291,879

 
292,457


The following table sets forth the total interest expense recognized related to the Initial Term Loan for the three months ended March 31, 2018 (in thousands). The Initial Term Loan was drawn in October 2017. Therefore, there was no interest expense for the three months ended March 31, 2017 associated with the Initial Term Loan.

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SHUTTERFLY, INC.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

 
Three Months Ended
 
March 31,
 
2018
 
2017
Floating interest (including the effects of cash flow hedges)
3,279

 

Amortization of debt issuance costs
172

 

 
3,451

 


0.25% Convertible Senior Notes Due May 15, 2018
In May 2013, the Company issued $300 million aggregate principal amount of 0.25% convertible senior notes (the "Notes") due May 15, 2018, unless earlier purchased by the Company or converted. Interest is payable semiannually in arrears on May 15 and November 15 of each year, commencing on November 15, 2013.
The Notes are governed by an Indenture between the Company, as issuer, and Wells Fargo Bank, National Association, as trustee. The Notes are unsecured and rank senior in right of payment to the Company's future indebtedness that is expressly subordinated in right of payment to the Notes and rank equal in right of payment to the Company's existing and future liabilities that are not so subordinated and are effectively subordinated in right of payment to any of the Company's cash equal to the principal amount of the Notes, and secured indebtedness to the extent of the value of the assets securing such indebtedness and are structurally subordinated to all existing and future indebtedness and liabilities incurred by the Company's subsidiaries.
Upon conversion, the Company will pay or deliver, as the case may be, cash, shares of the Company's common stock or a combination of cash and shares of common stock, at the Company's election.
The initial conversion rate is 15.5847 shares of common stock per $1,000 principal amount of Notes. The initial conversion price is $64.17 per share of common stock. Throughout the term of the Notes, the conversion rate may be adjusted upon the occurrence of certain events. Holders of the Notes will not receive any cash payment representing accrued and unpaid interest upon conversion of a Note. Accrued but unpaid interest will be deemed to be paid in full upon conversion rather than cancelled, extinguished or forfeited. Holders may convert their Notes only under the following circumstances:

during any calendar quarter commencing after the calendar quarter ending on September 30, 2013 (and only during such calendar quarter), if the last reported sale price of the Company's common stock for at least 20 trading days (whether or not consecutive) during a period of 30 consecutive trading days ending on the last trading day of the immediately preceding calendar quarter is greater than or equal to 130% of the conversion price on each applicable trading day;
during the five business day period after any ten consecutive trading day period (the “Notes Measurement Period”) in which the "trading price" (as the term is defined in the Indenture) per $1,000 principal amount of notes for each trading day of such Notes Measurement Period was less than 98% of the product of the last reported sale price of the Company's common stock on such trading day and the conversion rate on each such trading day;
upon the occurrence of specified corporate events; or
at any time on or after December 15, 2017 until the close of business on the second scheduled trading immediately preceding the maturity date.
As of March 31, 2018, the Notes are convertible. As of March 31, 2018, if the Notes were converted, the if-converted value would exceed its principal amount by $79.9 million.
In accounting for the issuance of the Notes, the Company separated the Notes into liability and equity components. The carrying amount of the liability component was calculated by measuring the fair value of a similar liability that does not have an associated convertible feature. The carrying amount of the equity component representing the conversion option was determined by deducting the fair value of the liability component from the face value of the Notes as a whole. The excess of the principal amount of the liability component over its carrying amount (“debt discount”) is amortized to interest expense over the term of the Notes. The equity component is not remeasured as long as it continues to meet the conditions for equity classification.
In accounting for the transaction costs related to the Note issuance, the Company allocated the total amount incurred to the liability and equity components based on their relative values. Issuance costs attributable to the liability component, totaling $6.4 million, are being amortized to expense over the term of the Notes, and issuance costs attributable to the equity component, totaling $1.7 million, were netted with the equity component in stockholders' equity. Additionally, the Company recorded a deferred tax asset of $0.6 million on a portion of the equity component transaction costs which are deductible for tax purposes.

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SHUTTERFLY, INC.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

Concurrently with the Note issuance, the Company repurchased 0.6 million shares of common stock for approximately $30.0 million.
The Notes consist of the following (in thousands):
 
March 31, 2018
 
December 31, 2017
Liability component:
 
 
 
Principal
$
300,000

 
$
300,000

Less: debt issuance costs, debt discount, net of amortization
(1,996
)
 
(5,946
)
Net carrying amount (classified as current)
$
298,004

 
$
294,054

 
 
 
 
Equity component (1)
$
63,510

 
$
63,510


(1)
Recorded in the consolidated balance sheets within additional paid-in capital, net of the $1.7 million of issuance costs in equity.

The following table sets forth total interest expense recognized related to the Notes (in thousands):
 
Three Months Ended
 
March 31,
 
2018
 
2017
0.25% coupon
$
187

 
$
187

Amortization of debt issuance costs
361

 
341

Amortization of debt discount
3,589

 
3,394

 
$
4,137

 
$
3,922

 
Note Hedge
To minimize the impact of potential economic dilution upon conversion of the Notes, the Company entered into convertible note hedge transactions with respect to its common stock (the “Note Hedge”). In May 2013, the Company paid an aggregate amount of $63.5 million for the Note Hedge. The Note Hedge will expire upon maturity of the Notes. The Note Hedge is intended to offset the potential dilution upon conversion of the Notes and/or offset any cash payments the Company is required to make in excess of the principal amount upon conversion of the Notes in the event that the market value per share of the Company's common stock, as measured under the Notes, is greater than the strike price of the Note Hedge, which initially corresponds to the conversion price of the Notes and is subject to anti-dilution adjustments substantially similar to those applicable to the conversion rate of the Notes.
Warrant
Separately, in May 2013, the Company entered into warrant transactions (the “Warrant”), whereby the Company sold warrants to acquire shares of the Company's common stock at a strike price of $83.18 per share. The Company received aggregate proceeds of $43.6 million from the sale of the Warrant. If the average market value per share of the Company's common stock for the reporting period, as measured under the Warrant, exceeds the strike price of the Warrant, the Warrant will have a dilutive effect on the Company's earnings per share. The Warrant is a separate transaction, entered into by the Company and is not part of the Notes or the Note Hedge, and has been accounted for as part of additional paid-in capital. Holders of the Notes and Note Hedge will not have any rights with respect to the Warrant.

Note 9 — Segment Reporting

The Company reports segment information based on its internal reporting used by management for making decisions and assessing performance as the source of its reportable segments.
    
The Chief Operating Decision Maker ("CODM") function uses gross profit to evaluate the performance of the segments and allocate resources. Management considers gross margin to be the appropriate metric to evaluate and compare the ongoing performance of each reportable segment as it is the level at which direct costs associated with the performance of the segment are

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SHUTTERFLY, INC.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

monitored. Cost of net revenues for the Consumer segment consists of costs incurred to produce personalized products for all of the Company's brands. These costs include direct materials (the majority of which consists of paper, ink, and photo book covers), shipping charges, packing supplies, distribution and fulfillment activities, third-party costs for photo-based merchandise, payroll and related expenses for direct labor and customer service, rent for production facilities, and depreciation of production equipment (primarily digital printing presses and binders) and manufacturing facilities. Cost of net revenues also includes amortization of capitalized website and software development costs, primarily related to adding features and functionality to the Company's website and apps to facilitate product purchases and improve the customer shopping experience. These costs include amortization of third-party software and acquired developed technology as well as patent royalties. Cost of net revenues also includes inventory markdowns that are part of restructuring activities. Cost of net revenues for the SBS segment consists of costs which are direct and incremental to the SBS business. These include production costs of SBS products, such as materials, labor and printing costs and costs associated with third-party production of goods. They also include shipping costs and indirect overhead.

Due to the nature of the Company's operations, a majority of its assets are utilized across all segments. In addition, segment assets are not reported to, or used by, the CODM to allocate resources or assess performance of the Company's segments. Accordingly, the Company has not disclosed asset information by segment.
The Company’s segments are determined based on the products and services it provides and how the CODM evaluates the business. The Company has the following reportable segments:
Consumer - Includes sales from the Company's brands and are derived from the sale of a variety of products, such as cards and stationery, professionally-bound photo books, home décor, personalized gifts, high quality prints, and other photo-based merchandise, and related shipping revenues, as well as rental revenue from its BorrowLenses brand. Revenue from advertising displayed on the Company's websites is also included in Consumer revenues.
SBS - Includes revenues from personalized direct marketing and other end-consumer communications as well as just-in-time, inventory-free printing for the Company's business customers.

In addition to the above reportable segments, the Company has a corporate category that includes activities that are not directly attributable or allocable to a specific segment. This category consists of stock-based compensation expense and amortization of intangible assets.
The Company’s segment results for the three months ended March 31, 2018 and 2017 were as follows (dollars in thousands):

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SHUTTERFLY, INC.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

 
Three Months Ended
 
March 31,
 
2018
 
2017
Consumer
 
 
 
Net revenues
$
152,059

 
$
160,645

Cost of net revenues
84,845

 
89,854

Restructuring

 
1,240

Gross profit
$
67,214

 
$
69,551

Gross profit as a percentage of net revenues
44
%
 
43
%
 
 
 
 
Shutterfly Business Solutions (SBS)
 
 
 
Net revenues
$
47,666

 
$
31,327

Cost of net revenues
39,910

 
23,838

Gross profit
$
7,756

 
$
7,489

Gross profit as a percentage of net revenues
16
%
 
24
%

 
 
 
Corporate
 
 
 
Net revenues
$

 
$

Cost of net revenues
1,291

 
2,427

Gross profit
$
(1,291
)
 
$
(2,427
)

 
 
 
Consolidated
 
 
 
Net revenues
$
199,725

 
$
191,972

Cost of net revenues
126,046

 
116,119

Restructuring

 
1,240

Gross profit
$
73,679

 
$
74,613

Gross profit as a percentage of net revenues
37
%
 
39
%

Note 10 — 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.

Legal Matters

The Company is subject to the various legal proceedings and claims discussed below as well as certain other legal proceedings and claims that have not been fully resolved and that have arisen in the ordinary course of business. Although adverse decisions (or settlements) may occur in one or more of these cases, it is not possible to estimate the possible loss or losses from each of these cases. The final resolution of these lawsuits, individually or in the aggregate, is not expected to have a material adverse effect on

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SHUTTERFLY, INC.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

the Company's business, financial position or results of operations. Cases that previously were disclosed may no longer be described because of rulings in the case, settlements, changes in the Company's business or other developments rendering them, in the Company's judgment, no longer material to the Company's business, financial position or results of operations.

The State of Delaware v. Shutterfly, Inc.

On May 1, 2014, the State of Delaware filed a complaint against Shutterfly for alleged violations of the Delaware False Claims and Reporting Act, 6 Del C. § 1203(b)(2). The complaint asserts that Shutterfly failed to report and remit to Delaware cash equal to the balances on unused gift cards under the Delaware Escheats Law, 12 Del. C. § 1101 et seq. The Company believes the suit is without merit.

Monroy v. Shutterfly, Inc.
 
On November 30, 2016, Alejandro Monroy on behalf of himself and all others similarly situated, filed a complaint against us in the U.S. District Court for the Northern District of Illinois. The complaint asserts that the Company violated the Illinois Biometric Information Privacy Act by extracting his and others’ biometric identifiers from photographs and seeks statutory damages and an injunction. The Company believes the suit is without merit and intends to vigorously defend against it.

Taylor v. Shutterfly, Inc.

On December 12, 2017, Megan Taylor filed a purported class action complaint on behalf of herself and other customers in the U.S. District Court for the Northern District of California. Taylor alleges that the Company misrepresents a deal it currently offers through Groupon because it does not allow purchasers of the Groupon offer to combine or “stack” it with other promotional codes offered by the Company. The Company believes the suit is without merit and intends to vigorously defend against it.

Vigilant v Meek et al.

On March 1, 2018, a purported class action complaint was filed against several directors of Lifetouch, Inc. (which became a direct wholly-owned subsidiary of Shutterfly on April 2, 2018) and the trustee of the Lifetouch Employee Stock Ownership Plan (the “ESOP”) in the U.S. District Court for the District of Minnesota. On April 2, 2018, the complaint was amended to include the prior ESOP trustees and plan sponsor (Lifetouch) as additional named defendants. The complaint alleges violations of the Employee Retirement Income Security Act, including that the ESOP should not have been permitted to continue investing in Lifetouch stock during a period in which the Lifetouch stock price was declining. Lifetouch believes this suit is without merit and intends to vigorously defend against it.

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 the Company had previously accrued. There are no amounts accrued which the Company believes would be material to its financial position and results of operations.


Note 11 — Share Repurchase Program

On October 24, 2012, the Company's Board of Directors conditionally authorized and the Audit Committee subsequently approved a share repurchase program for up to $60.0 million of the Company's common stock. As of March 31, 2018, the Company's Board of Directors had approved increases to the program on the following dates:
On February 6, 2014, the Company's Board of Directors approved an increase of $100.0 million in addition to any amounts repurchased as of that date.
On February 9, 2015, the Company's Board of Directors approved an increase of $300.0 million in addition to any amounts repurchased as of that date.
On April 21, 2016, the Company's Board of Directors approved an increase of $100.0 million in addition to any amounts repurchased as of that date.

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SHUTTERFLY, INC.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

On April 18, 2017, the Company's Board of Directors approved an increase of $140.0 million in addition to any amounts repurchased as of that date.
The Company suspended its share repurchase program as of December 31, 2017 and we have publicly committed to maintaining a BB rating profile, and repaying acquisition debt, accordingly.
The share repurchase program is subject to prevailing market conditions and other considerations; does not require the Company to repurchase any dollar amount or number of shares; and may be suspended or discontinued at any time. The share repurchase authorization, which was effective immediately, permits the Company to effect repurchases for cash from time to time through the open market, privately negotiated or other transactions, including pursuant to trading plans established in accordance with Rules 10b5-1 and 10b-18 of the Securities Exchange Act of 1934, as amended, or by a combination of such methods.
The following table provides information about our repurchase of shares of our common stock for fiscal years 2016, 2017, and 2018:
Period (1)
 
Total Number of Shares Purchased
 
Average Price Paid per Share
 
Total Dollar Value Spent on Repurchases (in thousands)
2016 Repurchases
 
2,524,752

 

$44.55

 

$112,488

2017 Repurchases
 
2,325,825

 

$47.29

 

$110,000

2018 Repurchases
 

 

 


(1)
All shares were purchased pursuant to the publicly announced share repurchase program described above. Shares are reported in a period based on the settlement date of the applicable repurchase. All repurchased shares of common stock have been retired.

Note 12 — Restructuring

2017 Restructuring Plan

During the first quarter of 2017, the Board of Directors approved, committed to and initiated a plan to significantly simplify the Consumer business during 2017 ("2017 Restructuring Plan"). As part of the plan, the following actions were taken:

During the second quarter of 2017, the Company reinvested in Tiny Prints as its premium cards & stationery brand and created a Tiny Prints boutique on a dedicated tab on Shutterfly.com;
During the second quarter of 2017, the MyPublisher brand was retired in favor of the industry leading Shutterfly Photo Books category; and
During the third quarter of 2017, the Company launched the new Shutterfly Wedding Shop and shut down the Wedding Paper Divas legacy website
Actions pursuant to the 2017 Restructuring Plan were substantially complete as of the the third quarter of 2017.
 
2015 Restructuring Plan

During 2015, the Company decided to discontinue the Treat brand as well as close the manufacturing operations in Elmsford, New York as part of the Company's strategic initiatives ("2015 Restructuring Plan"). Actions pursuant to the 2015 Restructuring Plan were substantially complete as of the first quarter of 2016.

Restructuring Activity

The following table summarizes the restructuring payments made during the three months ended March 31, 2018 (in thousands):


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SHUTTERFLY, INC.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

 
 
2017 Restructuring
 
2015 Restructuring
 
 
 
 
Property and equipment
 
Employee costs
 
Other costs
 
Other costs
 
Total
Balance as of December 31, 2017 [1]
 
1,050

 
379

 
417

 
1,393

 
3,239

Cash payments
 
(162
)
 
(298
)
 
(417
)
 
(38
)
 
(915
)
Balances as of March 31, 2018[1]
 
888

 
81

 

 
1,355

 
2,324

 
 
 
 
 
 
 
 
 
 
 
[1] The balances as of December 31, 2017 and March 31, 2018 are recorded in accrued liabilities and other non-current liabilities.


Note 13 — Derivative Financial Instruments
In August 2017, the Company entered into certain interest-rate swap agreements (“Swap Agreements”) with an aggregate notional amount of $150.0 million and an effective date of October 18, 2017. The Swap Agreements have the economic effect of modifying a portion of the variable interest-rate obligations associated with the Company’s secured delayed draw Initial Term Loan drawn in October 2017 so that the interest payable on such portion of the Initial Term Loan become fixed at a rate of 4.27% (refer to Note 8 - Debt for further details regarding the term loan facility). The Swap Agreements have a maturity date of August 17, 2023 as compared to August 17, 2024 for the Initial Term Loan. Further, the Initial Term Loan has an interest-rate floor, whereas the Swap Agreements do not include a floor. All other critical terms of the Swap Agreements correspond to the Initial Term Loan, including interest-rate reset dates and underlying market indices. The Company fully drew the Initial Term Loan on October 18, 2017 which is also the effective date of the Swap Agreements. The Company has asserted that it is probable that it will have sufficient outstanding debt throughout the life of the Swap Agreements.
The Company has designated the aforementioned Swap Agreements as qualifying hedging instruments and is accounting for them as cash flow hedges pursuant to ASC 815 (as amended by ASU 2017-12).
The fair value of the Swap Agreements were $5.7 million and $3.0 million as of March 31, 2018 and December 31, 2017, respectively, and was classified as other assets in the balance sheet. The unrealized gains recognized in other comprehensive income (loss) were $2.8 million and the amounts reclassified from other comprehensive income (loss) to interest expense during the three months ended March 31, 2018 were insignificant. Amounts expected to be reclassified from other comprehensive income into interest expense in the coming 12 months is $0.5 million. Interest expense (including the effects of the cash flow hedges) related to the portion of the Initial Term Loan subject to the aforementioned interest-rate swap agreements was $1.7 million for the three months ended March 31, 2018.
The Company does not use derivative financial instruments for trading purposes.


Note 14 — Subsequent Events

On January 30, 2018, the Company entered into a Stock Purchase Agreement (the “Purchase Agreement”) with Lifetouch, Inc. (“Lifetouch”) and Lifetouch Inc. Employee Stock Ownership Trust (the “Seller”). On April 2, 2018, pursuant to the Purchase Agreement, the Company completed the acquisition of 100% of the issued and outstanding shares of common stock of Lifetouch from the Seller. Under the terms of the Purchase Agreement, the consideration for the acquisition consisted of an all-cash purchase price of $825.0 million subject to certain adjustments based on a determination of closing net working capital, transaction expenses, cash and indebtedness. The Company financed the all-cash purchase price with an incremental $825.0 million term loan issuance under our existing credit agreement, which closed simultaneous with the acquisition.

Lifetouch provides the Company with a highly complementary business. The Company expects to gain access to many Lifetouch customers as Shutterfly customers, where they will benefit from Shutterfly’s leading cloud-photo management service, product creation capabilities, mobile apps, and broad product range. Lifetouch will be able to offer Shutterfly’s broader product range to Lifetouch customers, as well as to accelerate the development of Lifetouch’s online order-taking platform. The Company also expects to realize significant supply chain, manufacturing, and fulfillment synergies over time.

The Company elected to treat the acquisition of Lifetouch as an asset acquisition under section 338(h)(10) of the U.S. Internal Revenue Service tax code. As such, we expect the goodwill that we will recognize as part of the Lifetouch acquisition will be deductible for income tax purposes. The initial allocation of the purchase price for the acquisition of Lifetouch is pending the

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SHUTTERFLY, INC.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

completion of various analyses and finalization of estimates. Accordingly, such disclosures related to this business combination could not be made at the time these financial statements were issued.









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ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

CAUTIONARY NOTE REGARDING FORWARD-LOOKING STATEMENTS

This report, 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, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended, that are based upon our current expectations. These forward-looking statements include statements related to our business strategy and plans; growing and strengthening our talented leadership team; expanding our product range to Lifetouch customers; accelerating the development of Lifetouch’s online order-taking platform; realizing significant supply chain, manufacturing and fulfillment synergies over time; the seasonality of and growth of our business; the impact on us of general economic conditions, trends in key metrics such as total number of customers; total number of orders; and average order value; technology initiatives, expected SBS gross margins in the short and longer term; our capital expenditures for 2018; the sufficiency of our cash and cash equivalents and cash generated from operations for the next twelve months; our operating expenses remaining a consistent percentage of our net revenues; our manufacturing capabilities; our new production facilities; effective tax rates; outstanding convertible senior notes; the incremental term loan 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 “guidance,” “believe,” “anticipate,” “expect,” “estimate,” “intend,” “seek,” “continue,” “should,” “would,” “could,” “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, decreased consumer discretionary spending as a result of general economic conditions; our ability to expand our customer base and increase sales to existing customers; our ability to meet production requirements; our ability to retain and hire necessary employees, including seasonal personnel, and appropriately staff our operations; the impact of seasonality on our business; our ability to develop innovative, new products and services on a timely and cost-effective basis; failure to realize the anticipated benefits of our 2017 restructuring activities; the retention of Lifetouch employees and our ability to successfully integrate the Lifetouch businesses; consumer acceptance of our products and services; our ability to develop additional adjacent lines of business; successfully acquire businesses and technologies and to successfully integrate and operate these acquired businesses and technologies; unforeseen changes in expense levels; competition and the pricing strategies of our competitors, which could lead to pricing pressure; the anticipated benefits of expanding the portions of our public cloud infrastructure 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

Shutterfly, Inc. was incorporated in the state of Delaware in 1999. In September 2006, we completed our initial public offering and our common stock is listed on The Nasdaq Global Select Market under the symbol “SFLY.” Our principal corporate offices are in Redwood City, California.

We are the leading digital retailer and manufacturer of high-quality personalized products and services. Our purpose is to share life’s joy by connecting people to what matters as the leading retailer and manufacturing platform for personalized products. 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.

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

Shutterfly leads the industry in personalized photo products and services. Shutterfly helps our customers turn their precious memories into lasting keepsakes with award-winning professionally-bound photo books, cards and stationery, custom home décor products and unique photo gifts as well as calendars and prints.

The Tiny Prints boutique offers premium cards and stationery, stylish announcements, invitations and personal stationery. The Tiny Prints boutique provides customers exclusive luxe designs curated from top stationery designers. Customers (celebrities and top designers alike) seek us out for our industry-leading designs and exceptional service.


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BorrowLenses is the premier online marketplace for high-quality photographic and video equipment rentals.

Groovebook is an iPhone and Android app and subscription service that prints up to 100 mobile phone photos in a Groovebook and mails it to customers every month.

Shutterfly Business Solutions (SBS) provides personalized direct marketing and other end-consumer communications as well as just-in-time, inventory-free printing for our business customers.

We generate most of our revenues by marketing and manufacturing a variety of products such as cards and stationery, professionally-bound photo books, personalized gifts and home décor, calendars and high-quality prints. We manufacture many of these items in our Fort Mill, South Carolina; Shakopee, Minnesota; and Tempe, Arizona production facilities. By operating our own production facilities, we can produce high-quality products, innovate rapidly, maintain a favorable cost structure and ensure timely shipment to customers, even during peak periods of demand. We also operate a network of partners and can seamlessly manage demand across it. Some of the products that are currently manufactured for us by third parties include calendars, mugs, ornaments, candles, pillows and blankets.

Substantially all our revenue is generated from sales originating in the United States and our sales cycle has historically been highly seasonal as approximately 50% of our total net revenues occur during our fiscal fourth quarter. Further, our Tiny Prints boutique generates approximately 70% of its revenue in the fourth quarter. Our operations and financial performance depend on general economic conditions in the United States, consumer sentiment, and the levels of 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.

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 network of new users and customers.

In addition to driving lower customer acquisition costs through multiple marketing channels, our users 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.

To successfully execute our strategies, we require a talented leadership team. As a result, we intend to continue our focus to attract, retain, and grow our team; and to build continuity and pursue executional excellence in our daily operations everywhere. By providing our employees with a great place to work, we believe that we continue to strengthen our high-performance culture.

On January 30, 2018, we entered into a Stock Purchase Agreement (the “Purchase Agreement”) with Lifetouch, Inc. (“Lifetouch”) and Lifetouch Inc. Employee Stock Ownership Trust (the “Seller”). On April 2, 2018, pursuant to the Purchase Agreement, we completed the acquisition of 100% of the issued and outstanding shares of common stock of Lifetouch from the Seller. Under the terms of the Purchase Agreement, the consideration for the acquisition consisted of an all-cash purchase price of $825.0 million subject to certain adjustments based on a determination of closing net working capital, transaction expenses, cash and indebtedness. We financed the all-cash purchase price with an incremental $825.0 million term loan issuance under our existing credit agreement, which closed simultaneous with the acquisition.

Lifetouch provides Shutterfly with a highly complementary business. We expect to gain access to many Lifetouch customers as Shutterfly customers, where they will benefit from Shutterfly’s leading cloud-photo management service, product creation capabilities, mobile apps, and broad product range. Lifetouch will be able to offer Shutterfly’s broader product range to Lifetouch customers, as well as to accelerate the development of Lifetouch’s online order-taking platform. We also expect to realize significant supply chain, manufacturing, and fulfillment synergies over time.

The initial allocation of the purchase price for the acquisition of Lifetouch is pending the completion of various analyses and finalization of estimates. Accordingly, such disclosures related to this business combination could not be made at the time these financial statements were issued.

Basis of Presentation


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Net Revenues.      Our net revenues are comprised of sales generated from Consumer and SBS segments.
 
Consumer. Our Consumer revenues include sales from all our brands and are derived from the sale of a variety of products such as, professionally-bound photo books, cards and stationery, custom home décor products and unique photo gifts, calendars and prints, and the related shipping revenues as well as rental revenue from our BorrowLenses brand. Revenue from advertising displayed on our websites is also included in Consumer revenues.
 
SBS.     Our SBS revenues are primarily from personalized direct marketing and other end-consumer communications as well as just-in-time, inventory-free printing for our business customers. We continue to focus our efforts in expanding our presence in this industry.

In addition to the two reportable segments, we also have a corporate category that includes activities that are not directly attributable or allocable to a specific segment. This category consists of stock-based compensation and amortization of intangible assets.

Our Consumer segment is subject to seasonal fluctuations. In particular, we generate a substantial portion of our revenues during the holiday season in the 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 segment, we monitor several key metrics including, total customers, total number of orders, and average order value.  

Total Customers.     We closely monitor total customers as a key indicator of demand. Total customers represent the number of transacting customers in a given period. An active customer is defined as one that has transacted in the last trailing twelve months. We seek to expand our customer base by empowering our existing customers with sharing and collaboration services, and by conducting integrated marketing and advertising programs. We also acquire new customers through customer list acquisitions.

Total Number of Orders.     We closely monitor total number of orders as a leading indicator of net revenue trends. We recognize 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 in approximately three business days after a customer places an order.
 
Average Order Value.     Average order value ("AOV") is Consumer net revenues for a given period divided by the total number of customer orders recorded during that same period. AOV is impacted by product sales mix and pricing and promotional strategies, including our promotions and competitor promotional activity. As a result, our AOV may fluctuate on a quarterly and annual basis.

Our SBS segment revenues are generated from personalized direct marketing and other end-consumer communications as well as just-in-time, inventory-free printing for our business customers.

We believe the analysis of these metrics and others described under "Non-GAAP Financial Measures" 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.   Our cost of net revenues is split between our Consumer and SBS segments and our Corporate category.

Consumer.    Cost of net revenues for the Consumer segment consists of costs incurred to produce personalized products for all our brands. These costs include direct materials (the majority of which consists of paper, ink, and photo book covers), shipping charges, packing supplies, distribution and fulfillment activities, third-party costs for photo-based merchandise, payroll and related expenses for direct labor and customer service, rent for production facilities, and depreciation of production equipment (primarily digital printing presses and binders) and manufacturing facilities. Cost of net revenues also includes amortization of capitalized website and software development costs, primarily related to adding features and functionality to our website and apps to facilitate product purchases and improve the customer shopping experience. These costs include amortization of third-party software and acquired

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developed technology as well as patent royalties. Cost of net revenues also includes inventory markdowns that are part of restructuring activities.

SBS.        Cost of net revenues for the SBS segment consists of costs which are direct and incremental to the SBS business. These include production costs of SBS products, such as materials, labor and printing costs, shipping costs, indirect overhead and depreciation as well as costs associated with third-party production of goods.

Corporate.    Our corporate category includes activities that are not directly attributable or allocable to a specific segment. This category consists of stock-based compensation expense and amortization of intangible assets.

Operating Expenses.  Operating expenses consist of technology and development, sales and marketing, general and administrative and restructuring expenses.

Technology and development expense consists primarily of salaries and benefits for employees and professional fees for contractors engaged in the maintenance and support of our website, developing features and functionality for our free photo storage service, and developing and maintaining internal infrastructure such as our ERP, internal reporting tools and network security and data encryption systems. These expenses include depreciation of computer and network hardware used to run our websites, store user photos and related data, and support our infrastructure, as well as amortization of software used to operate such hardware. 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, social media and online display advertising, radio advertising, television advertising, the purchase of keyword search terms and various strategic alliances. We utilize 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 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 interest on our convertible senior notes arising from amortization of debt discount, amortization of debt issuance costs and our 0.25% coupon payment, interest on our term loan issued in October 2017, costs associated with our syndicated credit facilities, and costs associated with our capital leases and build-to-suit lease financing obligations.

Interest and Other Income, Net.   Interest and other income, net primarily consists of the interest earned on our cash and investment accounts and realized gains and losses on the sale of our investments.

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. We are subject to taxation in the United States and Israel.

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.

Except for the accounting policy for revenue recognition that was updated as a result of the adoption of Accounting Standards Update No. ASU 2014-09, there have been no changes to our critical accounting policies and estimates described in our Annual

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Report on Form 10-K for the fiscal year ended December 31, 2017 that have had a material impact on our condensed consolidated financial statements and related notes.

Revenue Recognition Policy

We derive our revenues primarily from Consumer and SBS product sales, net of applicable sales tax and allowances for returns. Revenues are recognized when control of the promised products or services is transferred to our customers in an amount that reflects the consideration we expect to be entitled to in exchange for those products or services. Shipping charged to our customers is recognized upon shipment and the related shipping costs are recognized as cost of net revenues.

Consumer. Consumer revenues are primarily derived from the sale of products such as, professionally-bound photo books, cards and stationery, custom home décor products and unique photo gifts, calendars and prints, etc. Customers place Consumer product orders through our website or our mobile apps and pay primarily using credit cards. The credit card payments are charged, and revenue is recognized upon shipment of the fulfilled orders, which generally occurs upon delivering to the carrier. If multiple products are ordered together, each product is a separate performance obligation, and the transaction price is allocated to each performance obligation based upon standalone selling price as each performance obligation is satisfied. We generally determine the standalone selling prices based on the prices charged to our customers or using expected cost plus margin.

For flash deal promotions through group buying websites, we recognize revenue on a gross basis, as we are the primary obligor, when redeemed items are shipped. Revenues from sales of flash deal promotions are deferred until shipment of fulfilled orders or until unredeemed flash deal promotions are recognized as breakage revenue. We recognize the expected breakage amounts as revenue in proportion to the pattern of rights exercised by the customer.

We periodically provide incentive offers to our new customers in exchange for setting up an account as well as our existing customers to encourage purchases. These incentive offers are readily available to all of our customers. Therefore, these do not represent a performance obligation as our customers are not required to enter into any enforceable commitment by receiving these incentive offers. The discounts are treated as a price reduction when discounts accepted and used by customers. Production costs related to free products are included in cost of revenues upon redemption.

SBS. SBS revenues are derived from personalized direct marketing and other end-consumer communications as well as just-in-time, inventory-free printing for our business customers. The services that we promise to our SBS customers are typically composed of a series of services that are performed over time. We account for these series of services as one performance obligation which represents a series of distinct services that are substantially the same and have the same pattern of transfer.

We recognize revenues from the satisfaction of performance obligations when we invoice our customers (that is, when we have the contractual right to bill under the contract). We have the contractual right to consideration from our customers in an amount that corresponds directly with the value to the customer of the services we have performed to date. For contracts that do not contain a significant non-refundable up-front fee, we apply the “right to invoice” practical expedient as we have the right to consideration from our customers in an amount that corresponds directly with the value to the customer of the services we have performed to date. For contracts that contain a significant non-refundable up-front fee, we consider whether these fees are related to the transfer of a promised good or service to the customer, and therefore represent a performance obligation. When the up-front fees do not represent a distinct performance obligation, we recognize revenue ratably over the period for which there is a significant termination contractual penalty.

Incremental direct costs of obtaining a contract consist of SBS sales commissions. We do not defer such incremental direct costs as the related performance obligations are satisfied within a short period of time and we elected to apply the practical expedient per ASC 340-40-25-4 related to expensing contract acquisition costs with the amortization period of less than one year. We do not provide any financing service to our customer as payment term.

Recent Accounting Pronouncements

Refer to Note 1 - The Company and Summary of Significant Accounting Policies of the financial statements for a discussion of the recent accounting pronouncements.


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Results of Operations

The following table presents the components of our statement of operations as a percentage of net revenues:
 
Three Months Ended
 
March 31,
 
2018
 
2017
Net revenues
100
 %
 
100
 %
Cost of net revenues
63
 %
 
60
 %
Restructuring
 %
 
1
 %
Gross profit
37
 %
 
39
 %
Operating expenses:
 
 
 
Technology and development
19
 %
 
24
 %
Sales and marketing
19
 %
 
22
 %
General and administrative
16
 %
 
15
 %
Restructuring
 %
 
4
 %
Total operating expenses
54
 %
 
65
 %
Loss from operations
(17
)%
 
(26
)%
Interest expense
(5
)%
 
(3
)%
Interest and other income, net
1
 %
 
 %
Loss before income taxes
(21
)%
 
(29
)%
Benefit from income taxes
7
 %
 
12
 %
Net loss
(14
)%
 
(17
)%


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Comparison of the Three Month Periods Ended March 31, 2018 and 2017
 
 
Three Months Ended March 31,
 
 
2018
 
2017
 
$ Change
 
% Change
 
 
(in thousands)
Consolidated
 
 
 
 
 
 
 
 
Net revenues
 
$
199,725

 
$
191,972

 
$
7,753

 
4
 %
Cost of net revenues
 
126,046

 
116,119

 
9,927

 
9
 %
Restructuring
 

 
1,240

 
(1,240
)
 
100
 %
Gross profit
 
$
73,679

 
$
74,613

 
$
(934
)
 
(1
)%
Gross profit as a percentage of net revenues
 
37
%
 
39
%
 
 
 
 
Gross profit excluding restructuring as a percentage of net revenues
 
37
%
 
40
%
 
 
 
 

Net revenues increased $7.8 million, or 4%, for the three months ended March 31, 2018 as compared to the same period in 2017. Revenue growth was attributable to an increase in revenue from the SBS segment offset by revenue declines in the Consumer segment. Cost of net revenues increased $9.9 million, or 9%, for the three months ended March 31, 2018 as compared to the same period in 2017. In the three months ended March 31, 2017, we recorded $1.2 million of restructuring charges which impacted the gross profit in that period. Gross margin decreased to 37% in the three months ended March 31, 2018 from 39% in the same period in 2017 primarily related to decline in gross margins in the SBS segment.

Consumer Segment

 
 
Three Months Ended March 31,
 
 
2018
 
2017
 
$ Change
 
% Change
 
 
(in thousands)
Consumer
 
 
 
 
 
 
 
 
Net revenues
 
$
152,059

 
$
160,645

 
$
(8,586
)
 
(5
)%
Cost of net revenues
 
84,845

 
89,854

 
(5,009
)
 
(6
)%
Restructuring
 

 
1,240

 
(1,240
)
 
100
 %
Gross profit
 
$
67,214

 
$
69,551

 
$
(2,337
)
 
(3
)%
Gross profit as a percentage of net revenues
 
44
%
 
43
%
 
 
 
 
Gross profit excluding restructuring as a percentage of net revenues
 
44
%
 
44
%
 
 
 
 
 
 
Three Months Ended March 31,
 
 
2018
 
2017
 
Change
 
% Change
 
 
(in thousands, except AOV amounts)
Key Consumer Metrics
 
 
Total Customers
 
3,221

 
3,365

 
(144
)
 
(4
)%
Total Number of Orders
 
5,076

 
5,535

 
(459
)
 
(8
)%
Average order value (AOV)
 
$
29.96

 
$
29.02

 
$
0.94

 
3
 %

Consumer net revenues decreased $8.6 million, or 5%, in the three months ended March 31, 2018 compared to the same period in 2017. Growth in the Shutterfly brand and continued rapid mobile growth was offset by anticipated revenue declines in the non-Shutterfly brands due to the platform consolidation and the brand shutdowns over the course of 2017.

The Shutterfly brand delivered organic growth of 10%, with solid performance across the business particularly in Photo Books as well as in the Shutterfly Wedding Shop, which was launched in the third quarter of 2017. As expected, this healthy Shutterfly brand growth was offset by a loss of revenue from the three websites we shuttered in 2017: Tiny Prints, Wedding Paper Divas, and MyPublisher.

Total customers decreased 4% and total number of orders decreased 8%, while AOV increased 3% in the three months ended March 31, 2018 compared to the same period in 2017. The decrease in total customers and total number of orders was primarily

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due to the consumer platform consolidation and a mix shift in personalized gifts and home décor away from free product promotions. AOV increased due to delivering more targeted pricing and promotions.

Consumer cost of net revenues decreased $5.0 million, or 6%, for the three months ended March 31, 2018 compared to the same period in 2017.

Consumer gross margin was 44% in the three months ended March 31, 2018, roughly flat compared to the same period in 2017 as manufacturing efficiencies and a more targeted pricing and promotion strategy were offset by product mix. Restructuring charges recorded during the three months ended March 31, 2017 related to the markdowns of inventories which were determined to be obsolete. These restructuring charges had an immaterial impact on gross margin for that period.

SBS Segment

 
 
Three Months Ended March 31,
 
 
2018
 
2017
 
$ Change
 
% Change
 
 
(in thousands)
Shutterfly Business Solutions (SBS)
 
 
 
 
 
 
 
 
Net revenues
 
$
47,666

 
$
31,327

 
$
16,339

 
52
%
Cost of net revenues
 
39,910

 
23,838

 
16,072

 
67
%
Gross profit
 
$
7,756

 
$
7,489

 
$
267

 
4
%
Gross profit as a percentage of net revenues
 
16
%
 
24
%
 
 
 
 

SBS net revenues increased $16.3 million, or 52%, in the three months ended March 31, 2018 compared to the same period in 2017. The increase in SBS net revenues is due to higher than expected volumes from a multi-year deal that we signed with an existing technology client in the third quarter of 2017.

SBS cost of net revenues increased $16.1 million, or 67%, for the three months ended March 31, 2018 as compared to the same period in 2017. SBS gross margin decreased to 16% in the three months ended March 31, 2018 from 24% in the same period in 2017 primarily due to the deal we signed with an existing technology client in the third quarter of 2017, which has lower gross margins during the initial ramp up period. We expect gross margins in connection with this strategic relationship to be lower during the initial ramp period and we are on track to improve gross margins in the second half of 2018.

Corporate Segment

 
 
Three Months Ended March 31,
 
 
2018
 
2017
 
$ Change
 
% Change
 
 
(in thousands)
Corporate
 
 
 
 
 
 
 
 
Net revenues
 
$

 
$

 
$

 
 %
Cost of net revenues
 
1,291

 
2,427

 
(1,136
)
 
(47
)%
Gross profit
 
$
(1,291
)
 
$
(2,427
)
 
$
1,136

 
(47
)%

Corporate cost of net revenues decreased $1.1 million, or 47% in the three months ended March 31, 2018 compared to the same period in 2017. The decrease in corporate cost of net revenues was primarily a result of a decrease in amortization of intangible assets as certain of our intangible assets became fully amortized.

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Three Months Ended March 31,
 
2018
 
2017
 
$ Change
 
% Change
 
(in thousands)
Technology and development
$
38,504

 
$
45,955

 
$
(7,451
)
 
(16
)%
Percentage of net revenues
19
%
 
24
%
 

 

Sales and marketing
$
37,720

 
$
42,887

 
$
(5,167
)
 
(12
)%
Percentage of net revenues
19
%
 
22
%
 

 

General and administrative
$
31,565

 
$
27,795

 
$
3,770

 
14
 %
Percentage of net revenues
16
%
 
15
%
 

 

Restructuring
$

 
$
7,736

 
$
(7,736
)
 
100
 %
Percentage of net revenues
%
 
4
%
 

 


Our technology and development expense decreased $7.5 million, or 16%, for the three months ended March 31, 2018, compared to the same period in 2017. As a percentage of net revenues, technology and development decreased to 19% in the three months ended March 31, 2018 from 24% in the three months ended March 31, 2017. The overall decrease is primarily due to a decrease of $1.6 million in salaries and benefits relating to decreased headcount due to the consumer platform consolidation, a decrease of $1.5 million due to lower depreciation of computer equipment, an increase of $1.8 million of capitalized software and website development costs, a decrease of $1.5 million in professional fees, and a decrease of $0.6 million in facilities costs.

At March 31, 2018, headcount in technology and development decreased by 9% compared to March 31, 2017, reflecting our strategic focus on improving our long-term operating efficiency through the consumer platform consolidation. In the three months ended March 31, 2018, we capitalized $9.0 million in eligible salary and consultant costs, including $0.3 million of stock-based compensation expense, associated with software developed or obtained for internal use, compared to $7.2 million capitalized in the three months ended March 31, 2017, which included $0.2 million of stock-based compensation expense.

Our sales and marketing expense decreased $5.2 million, or 12%, in the three months ended March 31, 2018 compared to the same period in 2017. As a percentage of net revenues, total sales and marketing expense decreased to 19% in the three months ended March 31, 2018 from 22% in the three months ended March 31, 2017. The decrease in our sales and marketing expense was due to a decrease of $3.5 million in marketing campaigns largely driven by more efficient external marketing spend as we migrated our smaller brands to the Shutterfly brand and platform as part of the consumer platform consolidation during 2017. There was also a decrease of $1.1 million in amortization of intangible assets as certain of our intangible assets became fully amortized, and a decrease of $1.0 million in salaries and benefits as a result of lower headcount.

Our general and administrative expense increased $3.8 million, or 14%, in the three months ended March 31, 2018 as compared to the same period in 2017. As a percentage of net revenues, general and administrative expense increased to 16% in the three months ended March 31, 2018 from 15% in the three months ended March 31, 2017. The increase in general and administrative expense was primarily due to $4.6 million in acquisition-related expenses incurred in the three months ended March 31, 2018 in connection with the acquisition of Lifetouch. Excluding these acquisition-related expenses, general and administrative expenses as a percentage of net revenues decreased to 14% in the three months ended March 31, 2018.
 
Three Months Ended March 31,
 
2018
 
2017
 
Change
 
(in thousands)
Interest expense
$
(9,633
)
 
$
(5,964
)
 
$
(3,669
)
Interest and other income, net
1,749

 
189

 
1,560


Interest expense was $9.6 million for the three months ended March 31, 2018 compared to $6.0 million during the same period in 2017. This increase is primarily driven by interest expense for the term loan drawn in October 2017.

Interest and other income, net was $1.7 million for the three months ended March 31, 2018 compared to $0.2 million during the same period in 2017. This increase is due to higher interest income resulting from higher cash equivalents and investment balances and higher interest rates.

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Three Months Ended March 31,
 
2018
 
2017
 
(in thousands)
Benefit from income taxes
$
14,829

 
$
22,341

Effective tax rate
35
%
 
40
%

We recorded an income tax benefit of $14.8 million and $22.3 million for the three months ended March 31, 2018 and 2017, respectively. Our effective tax rate was 35% for the three months ended March 31, 2018, compared to 40% for the three months ended March 31, 2017. This decrease was due to the new baseline effective tax rate primarily attributable to tax reform partially offset by incremental tax deductions from stock-based compensation.


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Liquidity and Capital Resources

At March 31, 2018, we had $419.4 million of cash and cash equivalents and $125.0 million of investments, primarily commercial paper and corporate bonds. In May 2013, we issued $300.0 million of 0.25% convertible senior notes due May 15, 2018 (the "Senior Notes"). In August 2017, we entered into a syndicated credit facility (the "Credit Agreement") which provides for (a) a five-year secured revolving loan facility in an aggregate principal amount of up to $200.0 million expiring in August 2022 (the "Revolving Loan Facility") and (b) a seven-year secured delayed draw term loan facility in an initial aggregate principal amount of up to $300.0 million expiring in August 2024 (the "Initial Term Loan"). The Credit Agreement permits us to add one or more incremental term loan facilities and/or increase the commitments for revolving loans subject to certain conditions.

In October 2017, we fully drew the $300 million Initial Term Loan under the Credit Agreement and we anticipate using the proceeds to repay the Senior Notes due in May 2018. On April 2, 2018, we entered into an amendment under the Credit Agreement for an incremental term loan in an aggregate principal amount of $825.0 million (the "Incremental Term Loan") to finance the acquisition of Lifetouch. The Incremental Term Loan also has a maturity date of August 2024. The Revolving Loan Facility remains undrawn and available to us as of March 31, 2018.

The Credit Agreement fits well with our overall capital structure strategy. We seek to maintain adequate financial capacity to manage our seasonal cash flows, ensure a reasonable degree of operational flexibility and invest in value-creating growth. We anticipate paying down our acquisition debt, and maintaining a BB rating profile. From there, we will continue to focus on optimizing capital allocation across organic re-investment in the business, further acquisitions, and returning excess capital to shareholders.

Below is our cash flow activity for the three months ended March 31, 2018:
 
Three Months Ended March 31,
 
2018
 
2017
 
(in thousands)
Consolidated Statements of Cash Flows Data:
 
 
 
Purchases of property and equipment
$
(8,075
)
 
$
(3,517
)
Capitalization of software and website development costs
(8,584
)
 
(7,602
)
Cash flows used in operating activities
(124,332
)
 
(72,386
)
Cash flows provided by (used in) investing activities
46,535

 
(31,139
)
Cash flows provided by (used in) financing activities
7,274

 
(24,184
)

We anticipate that our current cash balance and cash generated from operations will be sufficient to meet our strategic and working capital requirements, lease obligations, technology development projects, quarterly payments for the Initial Term Loan and Incremental Term Loan and repayment of the Senior Notes due in May 2018 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 additional equity. The sale of additional equity or convertible debt could result in significant dilution to our stockholders. Financing arrangements may not be available to us, or may not be in amounts or on terms acceptable to us.

Including the acquisition of Lifetouch, we anticipate that total 2018 capital expenditures will be approximately 5% of our expected 2018 net revenues for the combined company. These expenditures will be used to improve the mobile experience, to develop the SBS platform, to purchase technology and equipment to support the growth in our business, to increase our production capacity, to simplify the process of creating and purchasing personalized products and by continuing to expand the range of products we offer our customers, and to make developments to Shutterfly Photos. 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.


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The following table shows total capital expenditures including amounts accrued but not yet paid by category for the three months ended March 31, 2018 and 2017:
 
Three Months Ended March 31,
 
2018
 
2017
 
(in thousands)
Technology equipment and software
$
289

 
$
1,447

Percentage of total capital expenditures
2
%
 
15
%
Manufacturing equipment, building improvements and other
4,006

 
221

Percentage of total capital expenditures
30
%
 
2
%
Capitalized technology and development costs
8,941

 
7,727

Percentage of total capital expenditures
68
%
 
83
%
Total capital expenditures
$
13,236

 
$
9,395

Total capital expenditures percentage of net revenues
7
%
 
5
%

Operating Activities. For the three months ended March 31, 2018, net cash used in operating activities was $124.3 million, primarily due to our net loss of $27.2 million and the net change in operating assets and liabilities of $142.4 million. Net cash used in operating activities was adjusted for non-cash items including $22.6 million of depreciation and amortization expense, $11.7 million of stock-based compensation expense, $4.3 million provision from deferred income taxes, $4.1 million for amortization of debt discount and issuance costs, and $2.3 million of amortization of intangible assets.

For the three months ended March 31, 2017, net cash used in operating activities was $72.4 million, primarily due to our net loss of $33.2 million and the net change in operating assets and liabilities of $92.2 million. Net cash used in operating activities was adjusted for non-cash items including $23.0 million of depreciation and amortization expense, $11.5 million of stock-based compensation expense, $7.9 million of non-cash restructuring, $4.3 million of amortization of intangible assets, $3.7 million for amortization of debt discount and issuance costs, and $2.4 million provision from deferred income taxes.

Investing Activities. For the three months ended March 31, 2018, net cash provided by investing activities was $46.5 million, primarily due to proceeds from the maturities of investments of $72.1 million and proceeds from sale of property and equipment of $0.6 million. This was offset by $8.1 million cash used for capital expenditures, $8.6 million for capitalized software and website development, and $9.5 million to purchase investments.

For the three months ended March 31, 2017, net cash used in investing activities was $31.1 million. We used $3.5 million for capital expenditures. We also used $7.6 million for capitalized software and website development and $26.3 million to purchase investments. This was partially offset by proceeds from the maturities and sales of investments of $6.2 million.

Financing Activities. For the three months ended March 31, 2018, net cash provided by financing activities was $7.3 million, primarily related to the proceeds from the issuance of common stock from the exercise of stock options of $13.8 million. This was offset by $4.6 million cash used for payments of capital leases and financing obligations, $1.1 million for the payment of credit agreement issuance costs, and $0.8 million for principal payments on our Initial Term Loan.

For the three months ended March 31, 2017, net cash used in financing activities was $24.2 million. We used $20.0 million to repurchase shares of our common stock. We also used $4.3 million for payments of capital leases and financing obligations. This was offset by $0.1 million of proceeds from the issuance of common stock from the exercise of stock options.

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 three financial measures, Non-GAAP net income (loss), Non-GAAP net income (loss) per share and adjusted EBITDA which meet the definition of Non-GAAP financial measures. We define Non-GAAP net income (loss) and Non-GAAP net income (loss) per share as net income (loss) and net income (loss) per share excluding restructuring and acquisition-related costs, respectively. We define adjusted EBITDA as earnings before interest, taxes, depreciation, amortization, stock-based compensation, restructuring, and acquisition-related 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

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affecting our earnings and cash flows. Refer below for a reconciliation of Non-GAAP net loss, Non-GAAP net loss per share and adjusted EBITDA 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 Non-GAAP net loss, Non-GAAP net loss per share and Non-GAAP adjusted EBITDA as a percentage of net revenues for the three months ended March 31, 2018 and 2017 (in thousands except per share amounts):
 
Three Months Ended
 
March 31,
 
2018
 
2017
Net revenues
$
199,725

 
$
191,972

GAAP net loss
$
(27,165
)
 
$
(33,194
)
GAAP net loss % of net revenues
(14
)%
 
(17
)%
GAAP net loss per share
$
(0.83
)
 
$
(0.98
)
 
 
 
 
Non-GAAP net loss
$
(23,765
)
 
$
(28,166
)
Non-GAAP net loss % of net revenues
(12
)%
 
(15
)%
Non-GAAP net loss per share
$
(0.73
)
 
$
(0.84
)
 
 
 
 
Non-GAAP adjusted EBITDA
$
7,065

 
$
(1,915
)
Non-GAAP adjusted EBITDA % of net revenues
4
 %
 
(1
)%

For the three months ended March 31, 2018 and 2017, our Non-GAAP net loss was $23.8 million and $28.2 million, respectively. In addition, during the three months ended March 31, 2018 and 2017, Non-GAAP net loss per share was $0.73 and $0.84, respectively.

For the three months ended March 31, 2018 and 2017, our Non-GAAP adjusted EBITDA was $7.1 million and Non-GAAP adjusted EBITDA loss was $1.9 million, respectively.

By carefully managing our operating costs and capital expenditures, we are able to make the strategic investments we believe are necessary to grow and strengthen our business while maintaining the opportunity for full year adjusted EBITDA profitability.

The following is a reconciliation of Non-GAAP net loss, Non-GAAP net loss per share and Non-GAAP adjusted EBITDA to the most comparable GAAP measure, for the three months ended March 31, 2018 and 2017 (in thousands except per share amounts):


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  Reconciliation of Net Loss to Non-GAAP Net Loss and Non-GAAP Net Loss per Share
 
Three Months Ended
 
March 31,
 
2018
 
2017
GAAP net loss
$
(27,165
)
 
$
(33,194
)
Acquisition-related costs
4,585

 

Tax benefit impact of one-time charges
(1,185
)
 
(3,948
)
Restructuring

 
8,976

Non-GAAP net loss
$
(23,765
)
 
$
(28,166
)
 
 
 
 
GAAP diluted shares outstanding
32,702

 
33,712

Non-GAAP diluted shares outstanding
32,702

 
33,712

 
 
 
 
GAAP net loss per share
$
(0.83
)
 
$
(0.98
)
Non-GAAP net loss per share
$
(0.73
)
 
$
(0.84