Shutterfly, Inc.
SHUTTERFLY INC (Form: 10-Q, Received: 11/05/2013 06:02:23)
Table of Contents

 
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 September 30, 2013
 
or
o
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from            to
Commission file number 001-33031

SHUTTERFLY, INC.
(Exact Name of Registrant as Specified in Its Charter)
Delaware
 
94-3330068
( State or Other Jurisdiction of Incorporation or Organization)
 
(IRS Employer Identification No.)

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

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

Indicate by check mark whether the Registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes    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 or a smaller reporting company. See definition of “accelerated filer,” “large accelerated filer,” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.
Large accelerated Filer    x
Accelerated Filer    o
Non-accelerated Filer    o
Smaller reporting company o
(Do not check if a smaller reporting company)
Indicate by check mark whether the Registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes    o       No    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 at October 31, 2013
Common stock, $0.0001 par value per share
 
38,035,825
 



TABLE OF CONTENTS

 
Page
Number
Part I - Financial Information
 
Item 1. Financial Statements
 
Part II - Other Information
 
EXHIBIT 10.01
 
EXHIBIT 31.01
 
EXHIBIT 31.02
 
EXHIBIT 32.01
 
EXHIBIT 32.02
 
EXHIBIT 101
 








Table of Contents

PART I FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

Item 1. Condensed Consolidated Financial Statements

SHUTTERFLY, INC.
CONDENSED CONSOLIDATED BALANCE SHEETS
(In thousands, except par value amounts)
(Unaudited)
 
 
September 30, 2013
 
December 31, 2012
ASSETS
 
 
 
Current assets:
 
 
 
Cash and cash equivalents
$
335,140

 
$
245,088

Accounts receivable, net
15,640

 
13,574

Inventories
8,373

 
5,032

Deferred tax asset, current portion
20,811

 
7,713

Prepaid expenses and other current assets
70,758

 
15,268

Total current assets
450,722

 
286,675

Property and equipment, net
135,593

 
92,667

Intangible assets, net
120,241

 
122,269

Goodwill
379,675

 
358,349

Deferred tax asset, net of current portion
731

 
854

Other assets
15,783

 
4,310

Total assets
$
1,102,745

 
$
865,124

LIABILITIES AND STOCKHOLDERS’ EQUITY
 
 
 
Current liabilities:
 
 
 
Accounts payable
$
20,424

 
$
31,503

Accrued liabilities
40,751

 
88,472

Deferred revenue
21,025

 
17,845

Total current liabilities
82,200

 
137,820

Convertible senior notes, net
240,662

 

Deferred tax liability
28,817

 
24,298

Other liabilities
21,382

 
11,720

Total liabilities
373,061

 
173,838

Commitments and contingencies (Note 6)

 

Stockholders’ equity:
 
 
 
Common stock, $0.0001 par value; 100,000 shares authorized; 37,958 and 36,358 shares
issued and outstanding on September 30, 2013 and December 31, 2012, respectively
4

 
4

Additional paid-in capital
757,113

 
652,110

Accumulated earnings/(deficit)
(27,433
)
 
39,172

Total stockholders' equity
729,684

 
691,286

Total liabilities and stockholders' equity
$
1,102,745

 
$
865,124

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

3

Table of Contents

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

 
Three Months Ended
 
Nine Months Ended
 
September 30,
 
September 30,
 
2013
 
2012
 
2013
 
2012
Net revenues
$
122,685

 
$
98,536

 
$
372,854

 
$
288,847

Cost of net revenues
71,308

 
55,129

 
204,877

 
155,892

Gross profit
51,377

 
43,407

 
167,977

 
132,955

Operating expenses:
 

 
 

 
 

 
 

Technology and development
27,508

 
21,538

 
78,032

 
60,976

Sales and marketing
36,774

 
29,575

 
109,946

 
86,615

General and administrative
21,717

 
16,039

 
62,518

 
45,975

Total operating expenses
85,999

 
67,152

 
250,496

 
193,566

Loss from operations
(34,622
)
 
(23,745
)
 
(82,519
)
 
(60,611
)
Interest expense
(3,609
)
 
(148
)
 
(5,684
)
 
(456
)
Interest and other income, net
139

 
14

 
181

 
30

Loss before income taxes
(38,092
)
 
(23,879
)
 
(88,022
)
 
(61,037
)
Benefit from income taxes
27,944

 
13,401

 
53,658

 
31,008

Net loss
$
(10,148
)
 
$
(10,478
)
 
$
(34,364
)
 
$
(30,029
)
 
 
 
 
 
 
 
 
Net loss per share - basic and diluted
$
(0.27
)
 
$
(0.29
)
 
$
(0.92
)
 
$
(0.84
)
 
 
 
 
 
 
 
 
Weighted-average shares outstanding - basic and diluted
37,814

 
36,062

 
37,541

 
35,691

 
 
 
 
 
 
 
 
Stock-based compensation is allocated as follows:
 
 
 

 
 

 
 

Cost of net revenues
$
646

 
$
424

 
$
1,802

 
$
1,329

Technology and development
2,459

 
1,502

 
6,843

 
6,465

Sales and marketing
5,774

 
2,613

 
14,030

 
8,508

General and administrative
5,103

 
3,826

 
15,494

 
11,206


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

4

Table of Contents

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

 
Nine Months Ended
 
September 30,
 
2013
 
2012
Cash flows from operating activities:
 
 
 
Net loss
$
(34,364
)
 
$
(30,029
)
Adjustments to reconcile net loss to net cash used in operating activities:
 

 
 

Depreciation and amortization
30,652

 
19,327

Amortization of intangible assets
22,239

 
14,761

Amortization of debt discount and debt issuance costs
4,592

 

Stock-based compensation, net of forfeitures
38,169

 
27,508

(Gain) / loss on disposal of property and equipment
10

 
(895
)
Deferred income taxes
(7,988
)
 
(4,729
)
Tax benefit from stock-based compensation
4,745

 
14,938

Excess tax benefits from stock-based compensation
(5,385
)
 
(14,938
)
Changes in operating assets and liabilities:
 

 
 

Accounts receivable, net
(1,455
)
 
(1,587
)
Inventories
(2,426
)
 
(1,843
)
Prepaid expenses and other current assets
(53,774
)
 
(44,349
)
Other assets
(7,427
)
 
(30
)
Accounts payable
(10,670
)
 
3,790

Accrued and other liabilities
(50,735
)
 
(27,327
)
Deferred revenue
2,188

 
3,620

Other non-current liabilities
357

 
(407
)
Net cash used in operating activities
(71,272
)
 
(42,190
)
Cash flows from investing activities:
 

 
 

Acquisition of business and intangibles, net of cash acquired
(41,120
)
 
(35,683
)
Purchases of property and equipment
(48,550
)
 
(26,912
)
Capitalization of software and website development costs
(12,057
)
 
(9,603
)
Proceeds from sale of equipment
173

 
982

Net cash used in investing activities
(101,554
)
 
(71,216
)
Cash flows from financing activities:
 

 
 

Proceeds from borrowings on convertible senior notes, net of issuance costs
291,897

 

Proceeds from issuance of warrants
43,560

 

Purchase of convertible note hedge
(63,510
)
 

Proceeds from issuance of common stock upon exercise of stock options
18,275

 
8,538

Principal payments of capital lease obligations
(488
)
 

Repurchases of common stock
(32,241
)
 

Excess tax benefits from stock-based compensation
5,385

 
14,938

Net cash provided by financing activities
262,878

 
23,476

Net increase / (decrease) in cash and cash equivalents
90,052

 
(89,930
)
Cash and cash equivalents, beginning of period
245,088

 
179,915

Cash and cash equivalents, end of period
$
335,140

 
$
89,985

 
 
 
 

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


5

Table of Contents

 
Nine Months Ended
 
September 30,
 
2013
 
2012
Supplemental schedule of non-cash activities
 

 
 

Net increase / (decrease) in accrued purchases of property and equipment
$
(1,506
)
 
$
8,479

Increase in estimated fair market value of building under build-to-suit leases
4,552

 
4,850

Amount due from adjustment of net working capital from acquired business
73

 

Amount due for acquisition of business

 
165


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

6

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”) was incorporated in the state of Delaware in 1999 and began its services in December 1999. The Company is the leading manufacturer and digital retailer of high-quality personalized products and services offered through a family of lifestyle brands. The Company provides customers a full range of products and services to organize and archive digital images; share pictures; order prints and create an assortment of personalized items such as photo books, greeting cards and stationery and calendars. The Company also provides enterprise services; printing and shipping of direct marketing and other variable data print products and formats. The Company is headquartered in Redwood City, California.

Basis of Presentation

The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America for interim financial information and, accordingly, do not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements. The accompanying unaudited condensed consolidated financial statements include the accounts of Shutterfly, Inc. and its wholly owned subsidiaries. In the opinion of management, all adjustments, consisting primarily of normal recurring accruals, considered necessary for a fair statement of the Company’s results of operations for the interim periods reported and of its financial condition as of the date of the interim balance sheet have been included. Operating results for the three and nine months ended September 30, 2013 are not necessarily indicative of the results that may be expected for the year ending December 31, 2013 , or for any other period.

The December 31, 2012 condensed consolidated balance sheet data was derived from audited financial statements, but does not include all disclosures required by accounting principles generally accepted in the United States of America. These unaudited interim condensed consolidated financial statements should be read in conjunction with the consolidated financial statements and related notes for the year ended December 31, 2012 included in the Company’s Annual Report on Form 10-K.

Fair Value

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

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

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

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

As of September 30, 2013 and December 31, 2012 , the Company had cash of $335.1 million and $186.3 million , respectively, and had no cash equivalents as of September 30, 2013 as compared to $58.8 million as of December 31, 2012 , which were classified in the Level 1 hierarchy.

Income Taxes

The Company uses the liability method of accounting for income taxes. Under this method, deferred tax assets and liabilities are recognized by applying the statutory tax rates in effect in the years in which the differences between the financial reporting and tax filing bases of existing assets and liabilities are expected to reverse.
Valuation allowances are established when necessary to reduce deferred tax assets to the amounts expected to be realized from future taxable income. The Company's determination of its valuation allowance is based upon a number of assumptions, judgments, and estimates, including forecasted earnings, future taxable income, and the relative proportions of revenue and income before taxes in each jurisdiction.

7

SHUTTERFLY, INC.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

The Company reports a liability for unrecognized tax benefits resulting from uncertain tax positions taken or expected to be taken in a tax return. The application of income tax law is inherently complex. Laws and regulations in this area are voluminous and are often ambiguous. The Company is required to make subjective assumptions and judgments regarding its income tax exposures. Interpretations and guidance surrounding income tax laws and regulations change over time. As such, changes in the Company's subjective assumptions and judgments can materially affect amounts recognized in the consolidated balance sheets and statements of income.
The Company's policy is to recognize interest and /or penalties related to all tax positions in income tax expense. To the extent that accrued interest and penalties do not ultimately become payable, amounts accrued will be reduced and reflected as a reduction of the overall income tax provision in the period that such determination is made. No interest and penalties were accrued as of September 30, 2013 and December 31, 2012 .

The Company is subject to taxation in jurisdictions within the United States and Israel.

Recent Accounting Pronouncements

No new accounting standards have been adopted since the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 2012 was filed. The Company does not believe that any new accounting pronouncements not yet effective will have a material impact on the Company's financial statements once adopted.

Note 2 — Stock-Based Compensation

Stock Option Activity

A summary of the Company’s stock option activity for the three and nine months ended September 30, 2013 is as follows (share numbers and aggregate intrinsic values in thousands):
 
 
Number of
Options
Outstanding
 
Weighted
Average
Exercise
Price
 
Weighted
Average
Contractual
Term (Years)
 
Aggregate
Intrinsic
Value
Balances, December 31, 2012
2,034

 
$
17.09

 
 
 
 
Granted
2

 
32.99

 
 
 
 
Exercised
(947
)
 
13.08

 
 
 
 
Forfeited, cancelled or expired
(22
)
 
27.65

 
 
 
 
Balances, March 31, 2013
1,067

 
$
20.46

 
5.8
 
$
25,898

Granted

 

 
 
 
 
Exercised
(219
)
 
15.80

 
 
 
 
Forfeited, cancelled or expired
(26
)
 
14.48

 
 
 
 
Balances, June 30, 2013
822

 
$
21.89

 
5.7
 
$
27,992

Granted

 

 
 
 
 
Exercised
(141
)
 
17.22

 
 
 
 
Forfeited, cancelled or expired
(5
)
 
25.74

 
 
 
 
Balances, September 30, 2013
676

 
$
22.83

 
5.7
 
$
22,365

Options vested and expected to vest at September 30, 2013
658

 
$
22.58

 
5.6
 
$
21,948

Options vested at September 30, 2013
480

 
$
19.34

 
4.8
 
$
17,552

 
During the three months ended September 30, 2013 , the Company did not grant any options. The total intrinsic value of options exercised during the three months ended September 30, 2013 was $5,341,000 .  Net cash proceeds from the exercise of stock options were $2,422,000 and $18,275,000 for the three and nine months ended September 30, 2013 .


8

SHUTTERFLY, INC.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

Valuation of Stock Options

The Company estimated the fair value of each option award on the date of grant using the Black-Scholes option-pricing model and the assumptions noted in the following table.  In the three and nine months ended September 30, 2013 and 2012 , the Company calculated volatility using an average of its historical and implied volatilities. The expected term of options gave consideration to historical exercises, post-vesting cancellations and the options’ contractual term. The risk-free rate for the expected term of the option is based on the U.S. Treasury Constant Maturity at the time of grant. The assumptions used to value options granted during the three and nine months ended September 30, 2013 and 2012 were as follows:
 
 
Three Months Ended
 
Nine Months Ended
 
September 30,
 
September 30,
 
2013
 
2012
 
2013
 
2012
Dividend yield

 

 

 

Annual risk free rate of return

 
0.7
%
 
0.8
%
 
0.8
%
Expected volatility

 
55.6
%
 
47.0
%
 
57.9
%
Expected term (years)

 
4.3

 
4.2

 
4.3


Employee stock-based compensation expense recognized in the three and nine months ended September 30, 2013 and 2012 , was calculated based on awards ultimately expected to vest and has been reduced for estimated forfeitures. Forfeitures are estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates.

Restricted Stock Units

The Company grants restricted stock units (“RSUs”) to its employees under the provisions of the 2006 Equity Incentive Plan and inducement awards to eligible 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 three or four year total vesting term.  Compensation cost is amortized on a straight-line basis over the requisite service period.

Restricted Stock Unit Activity

A summary of the Company’s RSU activity for the three and nine months ended September 30, 2013 , is as follows (share numbers in thousands):
 
 
Number of
Units
Outstanding
 
Weighted
Average
Grant Date
Fair Value
Awarded and unvested, December 31, 2012
3,252

 
$
31.10

Granted
1,268

 
41.33

Vested
(664
)
 
28.66

Forfeited
(58
)
 
34.69

Awarded and unvested, March 31, 2013
3,798

 
$
34.89

Granted
176

 
48.40

Vested
(154
)
 
29.34

Forfeited
(46
)
 
37.14

Awarded and unvested, June 30, 2013
3,774

 
$
35.72

Granted
149

 
55.12

Vested
(177
)
 
32.44

Forfeited
(47
)
 
35.43

Awarded and unvested, September 30, 2013
3,699

 
$
36.66

RSUs expected to vest, September 30, 2013
3,252

 
 

 

9

SHUTTERFLY, INC.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

Included in the RSU grants for the nine months ended September 30, 2013 , are 355,000 RSUs that have both performance criteria tied to the Company’s 2013 financial performance and three year service criteria (“PBRSUs”).  Compensation cost associated with these PBRSUs is recognized on an accelerated attribution model and ultimately based on whether or not satisfaction of the performance criteria is probable. If in the future, situations indicate that the performance criteria are not probable, then no further compensation cost will be recorded and any previous costs will be reversed.

At September 30, 2013 , the Company had $94.2 million of total unrecognized 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 3 — Net Loss Per Share

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

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

A summary of the net loss per share for the three and nine months ended September 30, 2013 and 2012 is as follows (in thousands, except per share amounts):
 
 
Three Months Ended
 
Nine Months Ended
 
September 30,
 
September 30,
 
2013
 
2012
 
2013
 
2012
Net loss per share:
 
 
 
 
 
 
 
Numerator
 
 
 
 
 
 
 
Net loss
$
(10,148
)
 
$
(10,478
)
 
$
(34,364
)
 
$
(30,029
)
Denominator for basic and diluted net loss per share
 

 
 

 
 

 
 

Weighted-average common shares outstanding
37,814

 
36,062

 
37,541

 
35,691

Net loss per share — basic and diluted
$
(0.27
)
 
$
(0.29
)
 
$
(0.92
)
 
$
(0.84
)

Note 4 — Balance Sheet Components

Prepaid Expenses and Other Current Assets
 
 
September 30,
2013
 
December 31,
2012
 
(in thousands)
Intra-period deferred tax asset
$
50,395

 
$

Prepaid service contracts – current portion
5,608

 
5,771

Deferred costs
4,285

 
3,278

Other prepaid expenses and current assets
10,470

 
6,219

 
$
70,758

 
$
15,268

 
Intra-period deferred 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.


10

SHUTTERFLY, INC.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

Property and Equipment, Net

 
September 30,
2013
 
December 31,
2012
 
(in thousands)
Computer and other equipment
$
172,451

 
$
135,181

Software
19,330

 
17,342

Leasehold improvements
18,196

 
11,009

Buildings under build-to-suit leases
10,924

 
6,372

Furniture and fixtures
7,585

 
4,075

Capitalized software and website development costs
62,139

 
49,013

 
290,625

 
222,992

Less: Accumulated depreciation and amortization
(155,032
)
 
(130,325
)
Net property and equipment
$
135,593

 
$
92,667

 
Building value of $10.9 million under build-to-suit lease represents the estimated fair market value of buildings under build-to-suit leases of which the Company is the "deemed owner" for accounting purposes only. See Note 6 - Commitments and Contingencies for further discussion of the Company's build-to-suit leases.

Included within Computer and other equipment is approximately $6.4 million of capital lease obligations for various pieces of manufacturing facility and computer equipment.

Depreciation and amortization expense totaled $11.4 million and $6.6 million for the three months ended September 30, 2013 and 2012 , respectively. Depreciation and amortization expense totaled $30.7 million and $19.3 million for the nine months ended September 30, 2013 and 2012 , respectively.

   Accrued Liabilities
 
September 30,
2013
 
December 31,
2012
 
(in thousands)
Accrued compensation
$
11,301

 
$
13,904

Accrued production costs
8,221

 
22,534

Accrued marketing expenses
5,689

 
21,371

Accrued purchases
4,365

 
5,239

Accrued consulting
2,998

 
4,200

Accrued income and sales taxes
2,584

 
15,002

Capital lease obligations, current portion
1,548

 

Accrued other
4,045

 
6,222

 
$
40,751

 
$
88,472

 
Note 5 - Convertible Senior Notes

0.25% Convertible Senior Notes Due May 15, 2018
In May 2013, the Company issued $300.0 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

11

SHUTTERFLY, INC.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

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 September 30, 2013, the Notes are not yet convertible.
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.
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):
 
 
September 30, 2013
Liability component:
 
 
Principal
 
$
300,000

Less: debt discount, net of amortization
 
(59,338
)
Net carrying amount
 
$
240,662

 
 
 
Equity component (1)
 
$
63,510

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


12

SHUTTERFLY, INC.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

The following table sets forth total interest expense recognized related to the Notes (in thousands):
 
 
Three Months Ended
 
Nine Months Ended
 
 
September 30, 2013
 
September 30, 2013
0.25% coupon
 
$
188

 
$
281

Amortization of debt issuance costs
 
260

 
420

Amortization of debt discount
 
2,771

 
4,172

 
 
$
3,219

 
$
4,873

 
As of September 30, 2013, the fair value of the Notes, which was determined based on inputs that are observable in the market (Level 2) and carrying value of debt instruments (carrying value excludes the equity component of the Company's convertible notes classified in equity) were as follows:

 
 
September 30, 2013
 
December 31, 2012
 
 
Fair Value
 
Carrying Value
 
Fair Value
 
Carrying Value
Convertible Senior Notes
 
$
222,678

 
$
240,662

 

 


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 6 — Commitments and Contingencies

Build-to-Suit Leases
During the year ended December 31, 2012, the Company executed a lease for a new 300,000 square foot east coast production and customer service facility in Fort Mill, South Carolina. This facility replaces the Company's current east coast production facility in Charlotte, North Carolina. In order for the facility to meet the Company's operating specifications, both the landlord and the Company made structural changes as part of the uplift of the building, and as a result, the Company has concluded that it was the “deemed owner” of the building (for accounting purposes only) during the construction period. Accordingly, at lease inception, the Company recorded an asset of $4.9 million , representing its estimate of the fair market value of the building, and a corresponding construction financing obligation, recorded as a component of other non-current liabilities. The Company increased the asset and financing obligations by $1.5 million and $3.1 million for building uplift costs incurred by the landlord during 2012 and the nine months ended September 30, 2013, respectively.

During the quarter ended September 30, 2013, the Company executed a lease for a new 217,000 square foot production facility in Shakopee, Minnesota. This facility will provide additional production capacity, and is expected to become operational in the second quarter of 2014. Both the landlord and the Company will incur costs to construct the facility according to the

13

SHUTTERFLY, INC.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

Company's operating specifications, and as a result, the Company has concluded that it is the “deemed owner” of the building (for accounting purposes only) during the construction period. During the three months ended September 30, 2013, the landlord incurred $1.4 million of building construction costs which the Company has recorded as an asset, with a corresponding construction financing obligation, which is recorded as a component of other non-current liabilities. The Company will increase the asset and financing obligation as additional building uplift costs are incurred by the landlord during the construction period.

Upon completion of construction of these facilities, the Company evaluates the de-recognition of the asset and liability under the provisions of ASC 840.40 Leases - Sale-Leaseback Transactions. However, if the Company does not comply with the provisions needed for sale-leaseback accounting, the lease will be accounted for as a financing obligation and lease payments will be attributed to (1) a reduction of the principal financing obligation; (2) imputed interest expense; and (3) land lease expense (which is considered an operating lease and a component of cost of goods sold) representing an imputed cost to lease the underlying land of the facility. In addition, the underlying building asset will be depreciated over the building's estimated useful life which is generally 30 years. And at the conclusion of the lease term, the Company would de-recognize both the net book values of the asset and financing obligation.
Construction of the Fort Mill, South Carolina facility was completed in the second quarter of 2013, and at that time the Company concluded that it had forms of continued economic involvement in the facility. As a result, the Company did not comply with provisions for sale-leaseback accounting and the building is being accounted for as a financing obligation.

Co-location Services

During the three months ended September 30, 2013, the Company entered in a multi-year agreement for co-location services at a new data center location. The agreement requires certain minimum commitments during the term.

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.

Syndicated Credit Facility

On November 11, 2011, the Company entered into a credit agreement ("Credit Agreement") with J.P. Morgan Securities LLC, Wells Fargo Securities, LLC, Fifth Third Bank, Silicon Valley Bank, US Bank and Citibank, N.A. ("the Banks"). The Credit Agreement is for five years and provides for a $125.0 million senior secured revolving credit facility (the "credit facility") and if requested by the Company, the Banks may increase the credit facility by $75.0 million subject to certain conditions, for a total credit facility of $200.0 million .

On May 10, 2013, the Company amended the Credit Agreement by and among the Company and the Banks to (i) permit the issuance of the Notes and the related Note Hedge and Warrant, (ii) amend certain of the restrictive covenants set forth in the Credit Agreement, (iii) increase the Leverage Ratio (as defined the Credit Agreement) to be maintained by the Company to be at or below 3.50 to 1.00, and (iv) add a covenant requiring that the Company not permit its Senior Secured Leverage Ratio (as defined in the Credit Agreement) to exceed 1.60 to 1.00. As of September 30, 2013, the Company is in compliance with these covenants.

The Company incurred approximately $0.1 million of fees related to this amendment, which have been capitalized within prepaid expenses for the current portion and other assets for the non-current portion. These fees are being amortized over the remaining term of the Credit Facility as a component of interest expense.


14

SHUTTERFLY, INC.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

Legal Matters

On July 9, 2013, the Company filed a complaint for alleged patent infringement against Interactive Memories, Inc. (dba “Mixbook”) in the U.S. District Court for the District of Delaware. The complaint asserts infringement of U.S. Patent No. 7,082,227, which claims among other things, a method for personalizing an image-based physical manifestation to conform with a user's preferences for image processing and U.S. Patent No. 7,146,575, which claims among other things, a computer-implemented method for uploading image data to a remote computer and generating a thumbnail associated with the image. The complaint asserts that Mixbook directly or indirectly infringes the patents, and the Company is seeking an order enjoining Mixbook from further infringing the patents and an award of the Company's damages, costs, expenses and attorneys' fees.

On March 22, 2013, Shutterfly, Inc. filed a complaint for damages and injunctive relief against Kodak Imaging Network, Inc. and Eastman Kodak Company (together, “Kodak”) in Shutterfly, Inc. v. Kodak Imaging Network, Inc. and Eastman Kodak Company, Case No. 12-10202 (ALG) in the U.S. Bankruptcy Court, S.D.N.Y. The complaint asserts that by continuing to compete with Shutterfly through its “My Kodak Moments” service Kodak violated the non-competition provisions of the transfer agreement it entered into with the Company when the Company purchased the "Kodak Gallery" business. In the complaint, Shutterfly seeks an award of damages and its costs, expenses and attorneys' fees as well as an injunction enjoining Kodak from further violations of the non-competition provisions of the transfer agreement.

On March 7, 2013, CreateAds LLC filed a complaint for alleged patent infringement against the Company in CreateAds LLC v. Shutterfly, Inc., C.A. No. 13-00384 (GMS) in the U.S. District Court for the District of Delaware. The complaint asserts infringement of U.S. Patent No. 5,535,320, which claim among others things a method of generating a representation of a visual design and applying it to various advertising materials. The complaint asserts that the Company directly or indirectly infringes the patent without providing any details concerning the alleged infringement, and it seeks unspecified damages. The Company believes the suit is without merit.

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 7 Acquisitions
MyPublisher, Inc.
On April 29, 2013 , the Company acquired MyPublisher, Inc. ("MyPublisher") for a total aggregate cash purchase price of $40.4 million , or $38.7 million net of cash acquired. MyPublisher is one of the pioneers in the photo book industry and creator of easy-to-use photo book making software. The acquisition was accounted for as a non-taxable purchase transaction and, accordingly, the purchase price has been allocated to the acquired tangible assets, liabilities assumed, and identifiable intangible assets acquired based on their estimated fair values on the acquisition date. The excess of the purchase price over the aggregate fair values was recorded as goodwill.

Of the total purchase price, $9.5 million was allocated to the customer base, which will be amortized over an estimated useful life of four years, $7.8 million was allocated to developed technologies and will be amortized over an estimated useful life of approximately two years, $1.3 million to the MyPublisher tradename, which will be amortized over an estimated useful life of two years, and $0.1 million to favorable leases which will be amortized over an estimated useful life of five years. The assets and liabilities acquired totaled approximately $8.2 million and $7.9 million , respectively. Included within assets and liabilities is a net deferred tax liability of approximately $0.5 million representing the difference between the assigned values of the assets acquired and the tax basis of those assets, with the offset recorded as additional goodwill. The remaining excess purchase price of approximately $21.4 million was allocated to goodwill primarily representing the assembled workforce and synergies from MyPublisher's market position. The results of operations for the acquired business have been included in the consolidated statement of income for the period subsequent to the Company's acquisition of MyPublisher. MyPublisher's results of operations for periods prior to this acquisition were not material to the consolidated statement of operations and, accordingly, pro forma financial information has not been presented.


15

SHUTTERFLY, INC.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

R and R Images, Inc.
During the quarter ended September 30, 2013, the Company acquired certain assets of R and R Images, Inc. ("R&R") primarily to expand product innovation and printing capabilities. This acquisition was not significant individually or when aggregated with other acquisitions during the nine months ended September 30, 2013. The Company has included financial results of R&R in the consolidated financial statements from the acquisition date of August 29, 2013 through September 30, 2013.

Note 8 — Subsequent Event

On October 24, 2013, the Company acquired BorrowLenses for $35.8 million in cash, net of cash acquired. BorrowLenses is a premier online marketplace for photographic and video equipment rentals. This acquisition will diversify the Company's revenue streams and provide a presence in the expanding sharing economy.

16


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 and Section 21E of the Securities Exchange Act of 1934 that are based upon our current expectations. These forward-looking statements include statements related to our business strategy and plans, expectations regarding the seasonality 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, our capital expenditures for 2013, the sufficiency of our cash and cash equivalents and cash generated from operations for the next 12 months, our operating expenses remaining a consistent percentage of our net revenues, anticipated benefits from mergers and acquisitions and our plans to integrate acquired technologies and manufacturing capabilities, effective tax rates, our outstanding convertible senior notes, 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 “believe,” “anticipate,” “expect,” “estimate,” “intend,” “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, economic downturns and the general state of the economy; changes in consumer discretionary spending as a result of the macroeconomic environment; competition, which could lead to pricing pressure; our ability to expand our customer base and increase sales to existing customers and 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 technology on a timely basis, as well as consumer acceptance of, new products, features and services; our ability to successfully acquire businesses and technologies and to successfully integrate and operate these acquired businesses and technologies; our ability to achieve expected benefits of our partnerships; our ability to develop additional adjacent lines of business; unforeseen changes in expense levels; and our ability to timely upgrade and develop our infrastructure and facilities and the other risks set forth below under “Risk Factors” in Part II, Item 1A of this report. Given these risks and uncertainties, readers are cautioned not to place undue reliance on such forward-looking statements. We assume no obligation to update any of the forward-looking statements after the date of this report or to compare these forward-looking statements to actual results.

Overview
 
We are the leading manufacturer and digital retailer of high-quality personalized products and services offered through a family of lifestyle brands. Our vision is to make the world a better place by helping people share life’s joy. Our mission is to build an unrivaled service that enables deeper, more personal relationships between our customers and those who matter most in their lives.  Our primary focus is on helping consumers manage their memories through the powerful medium of photography. We provide a full range of personalized photo-based products and services that make it easy, convenient and fun for consumers to upload, edit, enhance, organize, find, share, create, print, and preserve their memories in a creative and thoughtful manner.

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

On May 25, 2012, we acquired Photoccino Ltd., a privately-held company based in Haifa, Israel, which has developed innovative technologies for photo ranking, analysis and organization that allows users to more efficiently organize and select the best photos from their ever-increasing archives so they can quickly and easily create photo books, calendars, cards, and photo gifts. Photoccino’s technology applies proprietary algorithms to analyze and evaluate the quality and content of photos, ranks them, and automatically creates photo products using the customer’s best images.  During the fourth quarter of 2012, we began to integrate the Photoccino technology by offering smart product creation capabilities to a select set of customers and have continued to integrate further the Photoccino technology into our products and services during 2013.


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On September 14, 2012, we acquired Penguin Digital, Inc., a mobile application development company that has an iPhone application that allows users to access their photos from iPhones or their Facebook or Instagram accounts and create customized products and gifts from their mobile devices. We subsequently introduced our new Shutterfly iPhone Photo App which combines storage, viewing and photo gift creation right from one's phone.

On December 28, 2012, we acquired ThisLife.com, Inc. (“ThisLife”) a cloud-based service provider for protecting, organizing, storing and sharing photos and videos which will strengthen our photo and video storage and sharing capabilities, as well as the ability to intelligently organize across devices and mobile platforms and enable the more efficient creation of products across the web and on mobile devices. We recently launched the beta version of our ThisLife service and we continue to expect to integrate this technology into the products and services that our Shutterfly brand offers.

On April 29, 2013, we acquired MyPublisher, Inc. ("MyPublisher") a pioneer in the photo book industry and creator of easy-to-use photo book-making software. We expect to combine MyPublisher's photo book technology and highly specialized manufacturing capabilities with our platform to expand our customer base and to enable us to further differentiate our product and service offerings.

And on October 24, 2013, the Company acquired BorrowLenses, a premier online marketplace for photographic and video equipment rentals. We expect BorrowLenses to diversify the Company's revenue streams and provide a presence in the expanding sharing economy. Operating results of BorrowLenses will be included in the Company's results for the fourth quarter of 2013.

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

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

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

In addition to driving lower customer acquisition costs through viral marketing, our customers provide input on new features, functionalities and products. Close, frequent customer interactions, coupled with significant investments in sophisticated integrated marketing programs, enable us to fine-tune and tailor our promotions and website presentation to specific customer segments. Consequently, customers are presented with a highly personalized shopping experience, which helps foster a unique and deep relationship with our brands.

Our operations and financial performance depend on general economic conditions in the United States, 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.

Basis of Presentation

Net Revenues.       Our net revenues are comprised of sales generated from our Consumer and Enterprise categories.

Consumer. Our Consumer revenues include sales from all of our brands and are derived from the sale of photo-based products, such as photo books, stationery and greeting cards, other photo-based merchandise, photo prints, and the related shipping revenues.  Included in our photo-based merchandise are items such as mugs, iPhone cases, mouse pads, desktop plaques and puzzles.  Photo prints consist of wallet, 4x6, 5x7, 8x10, and large format sizes.  Revenue from advertising displayed on our websites is also included in Consumer revenues.

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Enterprise. Our Enterprise revenues are primarily from variable, four-color direct marketing collateral manufactured and fulfilled for business customers.  We continue to focus our efforts in expanding our presence in this market.

Our business 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 category, we monitor several key metrics including, total customers, total number of orders, and average order value.  These metrics represent the aggregate of all customers and orders across all our Consumer brands.

Total Customers.      We closely monitor total customers as a key indicator of demand.  Total customers represents the number of transacting customers in a given period.  We seek to expand our customer base by empowering our existing customers with sharing and collaboration services (such as Shutterfly Share Sites), and by conducting integrated marketing and advertising programs. We also acquire new customers through customer list acquisitions. Total customers have increased on an annual basis for each year since inception and we expect this trend to continue.

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 two business days after a customer places an order. Total number of orders has increased on an annual basis for each year since 2000, and we anticipate this trend to continue in the future.
 
Average Order Value.      Average order value is Consumer net revenues for a given period divided by the total number of customer orders recorded during that same period. Average order value is impacted by product sales mix and pricing and promotional strategies, including our promotions and competitor promotional activity.  As a result, we expect that our average order values may fluctuate on an annual basis.
  
We believe the analysis of these metrics and the financial measures described below 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.        Cost of net revenues consists primarily of direct materials (the majority of which consists of paper, ink, and photo book covers), payroll and related expenses for direct labor, shipping charges, packaging supplies, distribution and fulfillment activities, rent for production facilities and equipment, depreciation of production equipment, and third-party costs for photo-based merchandise. Cost of net revenues also includes payroll and related expenses for personnel and third parties engaged in customer service, any third-party software or patents licensed, as well as the amortization of acquired developed technology, capitalized website and software development costs, and patent royalties.  Cost of net revenues also includes certain costs associated with facility closures and restructuring.

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

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

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

General and administrative expense includes general corporate costs, including rent for our corporate offices, insurance, depreciation on information technology equipment, and legal and accounting fees. Transaction costs are also included in general

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

Interest Expense.        Interest expense consists of interest on our convertible senior notes, costs associated with our five-year syndicated credit facility that became effective in November 2011, as amended in May 2013, 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.

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. Our critical accounting policies and estimates are discussed in our Annual Report on Form 10-K for the fiscal year ended December 31, 2012.

Results of Operations

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

 
Three Months Ended
 
Nine Months Ended
 
September 30,
 
September 30,
 
2013
 
2012
 
2013
 
2012
Net revenues
100
 %
 
100
 %
 
100
 %
 
100
 %
Cost of net revenues
58
 %
 
56
 %
 
55
 %
 
54
 %
Gross profit
42
 %
 
44
 %
 
45
 %
 
46
 %
Operating expenses:
 

 
 

 
 

 
 

Technology and development
22
 %
 
22
 %
 
21
 %
 
21
 %
Sales and marketing
30
 %
 
30
 %
 
29
 %
 
30
 %
General and administrative
18
 %
 
16
 %
 
17
 %
 
16
 %
Total operating expenses
70
 %
 
68
 %
 
67
 %
 
67
 %
Loss from operations
(28
)%
 
(24
)%
 
(22
)%
 
(21
)%
Interest expense
(3
)%
 
 %
 
(2
)%
 
 %
Interest and other income, net
 %
 
 %
 
 %
 
 %
Loss before income taxes
(31
)%
 
(24
)%
 
(24
)%
 
(21
)%
Benefit from income taxes
23
 %
 
13
 %
 
14
 %
 
11
 %
Net loss
(8
)%
 
(11
)%
 
(10
)%
 
(10
)%


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Comparison of the Three Month Periods Ended September 30, 2013 and 2012
 
 
Three Months Ended September 30,
 
2013

2012

$ Change

% Change
 
(in thousands)
Net revenues
 

 

 

 
Consumer
$
112,695


$
90,378


$
22,317


25
%
Enterprise
9,990


8,158


1,832


22
%
Total net revenues
122,685


98,536


24,149


25
%
Cost of net revenues
71,308


55,129


16,179


29
%
Gross profit
$
51,377


$
43,407


$
7,970


18
%
Percentage of net revenues
42
%

44
%




 
Net revenues increased $24.1 million , or 25% , for the three months ended September 30, 2013 as compared to the same period in 2012. Consumer net revenues increased $22.3 million , or 25% , in the three months ended September 30, 2013 compared to the same period in 2012.  The increase in Consumer net revenues is primarily a result of increased sales of greeting and stationery cards, photo books, including net revenues from the recently acquired MyPublisher brand, and other photo-based merchandise.  Enterprise revenues increased $1.8 million , or 22% , in the three months ended September 30, 2013 compared to the same period in 2012 due to an increase in order volume from both existing and new customers.
 
Consumer net revenue increases were also the result of year-over-year increases in each of our key metrics as outlined below. Improvements in average order value reflect the strength of our customer base and continued benefit from pricing and promotional initiatives.
 
Three Months Ended September 30,
 
2013
 
2012
 
$ Change
 
% Change
 
(in thousands, except AOV amounts)
Customers
2,381

 
2,247

 
134

 
6
%
Orders
3,877

 
3,606

 
271

 
8
%
Average order value
$
29.07

 
$
25.06

 
$
4.01

 
16
%
 
Cost of net revenues increased $16.2 million , or 29% , for the three months ended September 30, 2013 as compared to the same period in 2012. As a percentage of net revenues, cost of net revenues increased to 58% in the three months ended September 30, 2013 from 56% in the same period in 2012, which decreased gross margin to 42% in the three months ended September 30, 2013 from 44% in the same period in 2012. Overall, the increase in cost of net revenues was primarily the result of the increased volume of shipped products. The decrease in gross margin was primarily driven by higher depreciation and amortization, equipment lease expense and increased customer service expenses related to our new Fort Mill, South Carolina manufacturing facility, as well as lower average selling prices for a subset of products; which was partially offset by lower material costs related to our increased scale and insourcing, lower shipping rates as well as a favorable shift in product mix.

 
Three Months Ended September 30,
 
2013
 
2012
 
$ Change
 
% Change
 
(in thousands)
Technology and development
$
27,508

 
$
21,538

 
$
5,970

 
28
%
Percentage of net revenues
22
%
 
22
%
 

 

Sales and marketing
$
36,774

 
$
29,575

 
$
7,199

 
24
%
Percentage of net revenues
30
%
 
30
%
 

 

General and administrative
$
21,717

 
$
16,039

 
$
5,678

 
35
%
Percentage of net revenues
18
%
 
16
%
 

 


Our technology and development expense increased $6.0 million , or 28% , for the three months ended September 30, 2013 , compared to the same period in 2012. As a percentage of net revenues, technology and development expense remained consistent at 22% for the three months ended September 30, 2013 and 2012. The overall increase was primarily due to an increase of $4.5

21

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million in personnel and related costs due to increased headcount. The increase in technology and development expense was also due to an increase of $1.3 million in depreciation expense, an increase to stock-based compensation of $1.1 million , and an increase of $0.4 million in professional fees. These factors were partially offset by a decrease of $0.8 million in facilities and office supplies and an increase of $0.7 million in website developmental costs capitalized in the current period compared to the same period in the prior year.

At September 30, 2013 , headcount in technology and development increased by 34% compared to September 30, 2012, reflecting our strategic focus to increase the rate of innovation in our product and services offerings, to generate greater differentiation from our competitors, and improve our long-term operating efficiency. In the three months ended September 30, 2013 , we capitalized $4.3 million in eligible salary and consultant costs, including $0.4 million of stock-based compensation associated with software developed or obtained for internal use, compared to $3.6 million capitalized in the three months ended September 30, 2012, which included $0.3 million of stock-based compensation. 

Our sales and marketing expense increased $7.2 million , or 24% , in the three months ended September 30, 2013 compared to the same period in 2012. The increase in sales and marketing expense was primarily due to an increase of $3.2 million of stock-based compensation and an increase of $1.7 million in personnel and related costs associated with the expansion of our internal marketing team.  The increase is also attributable to an increase of $1.5 million related to brand and performance marketing campaigns, an increase of $0.5 million in intangible asset amortization from acquisition related intangibles, and an increase of $0.3 million related to professional fees. As a percentage of net revenues, total sales and marketing expense remained consistent at 30% in the three months ended September 30, 2013 and 2012.

Our general and administrative expense increased $5.7 million , or 35% , in the three months ended September 30, 2013 as compared to the same period in 2012. As a percentage of net revenues, general and administrative expense increased to 18% in the three months ended September 30, 2013 from 16% in the three months ended September 30, 2012. The increase in general and administrative expense is primarily due to an increase in depreciation and amortization of $1.5 million primarily from acquisition related intangibles, an increase in stock-based compensation of $1.3 million and an increase in personnel related costs of $1.3 million as a result of increased headcount. The increase was also attributable to an increase in professional fees of $0.8 million , an increase in credit card fees of $0.5 million which was driven by the increase in Consumer net revenues as compared to the prior year, an increase in gain on asset disposition of $0.2 million , and an increase in facilities costs of $0.2 million .
 
Three Months Ended September 30,
 
2013
 
2012
 
Change
 
(in thousands)
Interest expense
$
(3,609
)
 
$
(148
)
 
$
(3,461
)
Interest and other income, net
$
139

 
$
14

 
$
125


Interest expense consists of interest on our convertible senior notes, issuance costs associated with our convertible senior notes and credit facility, capital leases and our financing obligation associated with our Fort Mill, South Carolina production facility. Interest expense was $3.6 million for the three months ended September 30, 2013 compared to $0.1 million during the same period a year ago. The increase was primarily due to interest expense associated with our May 2013 issuance of $300.0 million of 0.25% convertible senior notes.
 
Three Months Ended
September 30,
 
2013
 
2012
 
(in thousands)
Income tax benefit
$
27,944

 
$
13,401

Effective tax rate
73
%
 
56
%

 We recorded an income tax benefit of $27.9 million and $13.4 million for the three months ended September 30, 2013 and 2012, respectively. Similar to the prior year, we expect this year-to-date loss to be fully benefited by the end of this fiscal year due to the seasonality of our operations. Our effective tax rate was 73% for the three months ended September 30, 2013 , compared to 56% for the three months ended September 30, 2012. Some of the primary factors impacting the effective tax rate include federal research tax credits, disqualifying dispositions of employee incentive stock options, limitations on executive compensation, and non-deductible stock-based compensation expense.


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Table of Contents

 
Three Months Ended September 30,
 
2013
 
2012
 
$ Change
 
% Change
 
(in thousands)
Loss before income taxes
$
(38,092
)
 
$
(23,879
)
 
$
(14,213
)
 
60
 %
Net loss
$
(10,148
)
 
$
(10,478
)
 
$
330

 
(3
)%
Percentage of net revenues
(8
)%
 
(11
)%
 

 


During the three months ended September 30, 2013 , net loss was $10.1 million , an increase of $0.3 million as compared to a net loss of $10.5 million the same period in 2012. As a percentage of net revenues, net loss was 8% for the three months ended September 30, 2013 from a net loss of 11% for the three months ended September 30, 2012.

Comparison of the Nine Month Periods Ended September 30, 2013 and 2012
 
 
Nine Months Ended September 30,
 
2013
 
2012
 
$ Change
 
% Change
 
(in thousands)
Net revenues
 
 
 
 
 
 
 
Consumer
$
347,395

 
$
269,910

 
$
77,485

 
29
%
Enterprise
25,459

 
18,937

 
6,522

 
34
%
Total net revenues
372,854

 
288,847

 
84,007

 
29
%
Cost of net revenues
204,877

 
155,892

 
48,985

 
31
%
Gross profit
$
167,977

 
$
132,955

 
$
35,022

 
26
%
Percentage of net revenues
45
%
 
46
%
 

 

 
Net revenues increased $84.0 million , or 29% , for the nine months ended September 30, 2013 as compared to the same period in 2012. Consumer net revenues increased $77.5 million , or 29% , in the nine months ended September 30, 2013 compared to the same period in 2012.  The increase in Consumer net revenues is primarily a result of increased sales of greeting and stationery cards, photo books, including net revenues from the recently acquired MyPublisher brand, and other photo-based merchandise.  Enterprise revenues increased $6.5 million , or 34% , in the nine months ended September 30, 2013 compared to the same period in 2012.
 
Cost of net revenues increased $49.0 million , or 31% , for the nine months ended September 30, 2013 as compared to the same period in 2012. As a percentage of net revenues, cost of net revenues increased to 55% in the nine months ended September 30, 2013 from 54% in the nine months ended September 30, 2012, and gross margin decreased to 45% in the nine months ended September 30, 2013 from 46% in the nine months ended September 30, 2012. Overall, the increase in cost of net revenues was primarily the result of the increased volume of shipped products.

 
Nine Months Ended September 30,
 
2013
 
2012
 
$ Change
 
% Change
 
(in thousands)
Technology and development
$
78,032

 
$
60,976

 
$
17,056

 
28
%
Percentage of net revenues
21
%
 
21
%
 

 

Sales and marketing
$
109,946

 
$
86,615

 
$
23,331

 
27
%
Percentage of net revenues
29
%
 
30
%
 

 

General and administrative
$
62,518

 
$
45,975

 
$
16,543

 
36
%
Percentage of net revenues
17
%
 
16
%
 

 


Our technology and development expense increased $17.1 million , or 28% , for the nine months ended September 30, 2013 , compared to the same period in 2012. As a percentage of net revenues, technology and development expense remained consistent at 21% for the nine months ended September 30, 2013 and 2012. The overall increase was primarily due to an increase of $11.9 million in personnel and related costs. The increase in technology and development expense was also due to an increase of $4.3 million in depreciation expense, an increase of $1.6 million in professional fees, and an increase in stock-based compensation of

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Table of Contents

$1.0 million . These factors were partially offset by an increase of $2.2 million in website developmental costs capitalized in the current period compared to the same period in the prior year. In the nine months ended September 30, 2013 , we capitalized $11.8 million in eligible salary and consultant costs, including $1.3 million of stock-based compensation, associated with software developed or obtained for internal use, compared to $9.6 million capitalized in the nine months ended September 30, 2012, which included $0.6 million of stock-based compensation. 

Our sales and marketing expense increased $23.3 million , or 27% , in the nine months ended September 30, 2013 compared to the same period in 2012. The increase in sales and marketing expense was primarily due to an increase of $7.6 million related to brand and performance marketing campaigns.  The increase is also attributable to an increase of $6.4 million in personnel and related costs associated with the expansion of our internal marketing team, an increase of $5.5 million in stock -based compensation, an increase of $2.9 million of intangible asset amortization primarily from the Kodak Gallery customer list and other acquisition related intangible assets, and an increase of $0.7 million of professional fees. As a percentage of net revenues, total sales and marketing expense decreased to 29% in the nine months ended September 30, 2013 as compared to 30% in the same period in 2012.

Our general and administrative expense increased $16.5 million , or 36% , in the nine months ended September 30, 2013 as compared to the same period in 2012. As a percentage of net revenues, general and administrative expense increase to 17% in the nine months ended September 30, 2013 compared to 16% in the nine months ended September 30, 2012. The increase in general and administrative expense is primarily due to an increase in stock-based compensation of $4.3 million , an increase in personnel related costs of $3.5 million as a result of increased headcount, and an increase of $3.0 million in depreciation and amortization expense. The increase was also attributable to an increase in credit card fees of $1.9 million which was driven by the increase in Consumer net revenues as compared to the prior year, an increase in professional fees of $1.5 million , an increase in facilities costs of $1.3 million , and a decrease in gain from the sale of assets of $0.9 million .
 
Nine Months Ended September 30,
 
2013
 
2012
 
Change
 
(in thousands)
Interest expense
$
(5,684
)
 
$
(456
)
 
$
(5,228
)
Interest and other income, net
$
181

 
$
30

 
$
151


Interest expense consists of interest on our convertible senior notes, issuance costs associated with our convertible senior notes and credit facility, capital leases and our financing obligation associated with our Fort Mill, South Carolina production facility. Interest expense was $5.7 million for the nine months ended September 30, 2013 compared to $0.5 million during the same period a year ago. The increase was primarily due to interest expense associated with our May 2013 issuance of $300.0 million of 0.25% convertible senior notes.

 
Nine Months Ended September 30,
 
2013
 
2012
 
(in thousands)
Income tax benefit
$
53,658

 
$
31,008

Effective tax rate
61
%
 
51
%

 We recorded an income tax benefit of $53.7 million and $31.0 million for the nine months ended September 30, 2013 and 2012, respectively. Similar to the prior year, we expect this year to date loss to be fully benefited by the end of this fiscal year due to the seasonality of our operation. Our effective tax rate was 61% for the nine months ended September 30, 2013, compared to 51% for the nine months ended September 30, 2012. Some of the primary factors impacting the effective tax rate include federal research tax credits, disqualifying dispositions of employee incentive stock options, limitations on executive compensation, and non-deductible stock-based compensation expense.


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Table of Contents

 
Nine Months Ended September 30,
 
2013
 
2012
 
$ Change
 
% Change
 
(in thousands)
Loss before income taxes
$
(88,022
)
 
$
(61,037
)
 
$
(26,985
)
 
44
%
Net loss
$
(34,364
)
 
$
(30,029
)
 
$
(4,335
)
 
14
%
Percentage of net revenues
(10
)%
 
(10
)%
 

 


Net loss increased by $4.3 million for the nine months ended September 30, 2013 as compared to the same period in 2012. As a percentage of net revenues, net loss remained flat at 10% for the nine months ended September 30, 2013 and 2012.

Liquidity and Capital Resources

At September 30, 2013 , we had $335.1 million of cash and cash equivalents. To supplement our overall liquidity position, during the nine months ended September 30, 2013 we issued $300.0 million of 0.25% convertible senior notes due May 15, 2018. Further, since November 2011, we have had access to a five-year senior secured syndicated credit facility to provide up to $125.0 million in additional capital resources. In addition, we may request to increase the credit facility by $75.0 million. As of September 30, 2013, no amounts have been drawn against this facility.

Below is our cash flow activity for the nine months ended September 30, 2013 and 2012:
 
 
Nine Months Ended September 30,
 
2013

2012
 
(in thousands)
Consolidated Statements of Cash Flows Data:
 

 
Purchases of property and equipment
$
(48,550
)

$
(26,912
)
Capitalization of software and website development costs
(12,057
)

(9,603
)
Depreciation and amortization
52,891


34,088

Proceeds from borrowings on convertible senior notes, net of issuance costs
291,897

 

Proceeds from issuance of warrants
43,560

 

Purchase of convertible note hedge
(63,510
)
 

Cash flows used in operating activities
(71,272
)

(42,190
)
Cash flows used in investing activities
(101,554
)

(71,216
)
Cash flows provided by financing activities
262,878


23,476


We anticipate that our current cash and cash equivalents balances and cash generated from operations will be sufficient to meet our strategic and working capital requirements, lease obligations, technology development projects, coupon payments for our 0.25% convertible senior notes, and to fund any repurchases of shares of our common stock under our share repurchase program announced in November 2012 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 additional dilution to our stockholders. Financing arrangements may not be available to us, or may not be in amounts or on terms acceptable to us.

We anticipate that total 2013 capital expenditures will range from 9.8% to 10.4% of our expected net revenues in 2013.  These expenditures will also be used to purchase technology and equipment to support the growth in our business and to increase our production capacity and help enable us to respond more quickly and efficiently to customer demand. A smaller but significant component of these expenditures includes costs associated with capitalized software and website development, as we continue to support our innovative engineering and product development strategies. This range of capital expenditures is not outside the ordinary course of our business or materially different from how we have expanded our business in the past.


25

Table of Contents

The following table shows total capital expenditures including amounts accrued but not yet paid by category for the nine months ended September 30, 2013 and 2012:
 
Nine Months Ended September 30,
 
2013
 
2012
 
(in thousands)
Technology equipment and software
$
24,002

 
$
20,469

Percentage of total capital expenditures
41
%
 
45
%
Manufacturing equipment and building improvements
23,042

 
14,922

Percentage of total capital expenditures
39
%
 
33
%
Capitalized technology and development costs
12,057

 
9,603

Percentage of total capital expenditures
20
%
 
21
%
Total Capital Expenditures
$
59,101

 
$
44,994

Total Capital Expenditures percentage of net revenues
16
%
 
16
%

Operating Activities. For the nine months ended September 30, 2013, net cash used in operating activities was $71.3 million , primarily due to our net loss of $34.4 million and the net change in operating assets and liabilities of $123.9 million . Net cash used in operating activities was adjusted for non-cash items including $38.2 million of stock-based compensation, $30.7 million of depreciation and amortization expense, $22.2 million of amortization of intangible assets and $8.0 million benefit from deferred income taxes.

For the nine months ended September 30, 2012, net cash used in operating activities was $42.2 million, primarily due to our net loss of $30.0 million and the net change in operating assets and liabilities of $68.1 million. Net cash used in operating activities was adjusted for non-cash items including $27.5 million of stock-based compensation, $19.3 million of depreciation and amortization expense, $14.8 million of amortization of intangible assets and $4.7 million benefit from deferred income taxes.

Investing Activities. For the nine months ended September 30, 2013, net cash used in investing activities was $101.6 million .  We used $41.1 million to acquire MyPublisher and R&R Images and to settle other acquisition related liabilities.  We also used $48.6 million for capital expenditures for computer and network hardware to support our website infrastructure and information technology systems and for production equipment for our manufacturing and production operations and $12.1 million for capitalized software and website development.

For the nine months ended September 30, 2012, net cash used in investing activities was $71.2 million. We used $24.4 million in the acquisition of Kodak Gallery's customer accounts and images and $4.5 million and $6.8 million in the acquisitions of Photoccino Ltd and Penguin Digital, Inc., respectively, net of cash acquired. We used $26.9 million for capital expenditures for computer and network hardware to support our website infrastructure and information technology systems, capital expenditures for production equipment for our manufacturing and production operations, and $9.6 million of capitalized software and website development. Additionally, we received proceeds of $1.0 million from the sale of equipment.

Financing Activities. For the nine months ended September 30, 2013, net cash provided by financing activities was $262.9 million , primarily from the $291.9 million in proceeds from the issuance of our 0.25% convertible senior notes in May 2013, $43.6 million in proceeds from the issuance of warrants, offset by $63.5 million from the purchase of a convertible note hedge and repurchases of common stock of $32.2 million . We also received $18.3 million of proceeds from issuance of common stock from the exercise of options and recorded $5.4 million from excess tax benefit from stock-based compensation.

In May 2013, we issued $300.0 million of 0.25% convertible senior notes due May 15, 2018 and concurrently entered into a convertible note hedge and warrant transaction. The notes will mature on May 15, 2018 unless earlier converted. Upon conversion of any notes, we will deliver cash, shares of common stock, or a combination of both, at our election, for the principal amount of the notes and any amounts in excess of the principal amount of the notes. The note issuance, note hedge and warrant transactions together, and including the expected tax benefits from the combined set of transactions, provided an overall low effective cost of borrowing. We expect to use these funds for general corporate purposes.

For the nine months ended September 30, 2012, net cash provided by financing activities was $23.5 million, primarily from $14.9 million from excess tax benefit from stock-based compensation and $8.5 million of proceeds from issuance of common stock from the exercise of options.


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Table of Contents

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, adjusted EBITDA, free cash flow, and Non-GAAP earnings per share which meet the definition of Non-GAAP financial measures. We define adjusted EBITDA as earnings before interest, taxes, depreciation, amortization, and stock-based compensation.  Free cash flow is defined as adjusted EBITDA less purchases of property and equipment and capitalization of software and website development costs.  Free cash flow has limitations due to the fact that it does not represent the residual cash flow for discretionary expenditures.  For example, free cash flow does not incorporate payments made on capital lease obligations or cash requirements to comply with debt covenants.  Non-GAAP earnings per share is defined as non-GAAP net income (loss), which excludes interest expense related to the issuance of our 0.25% convertible senior notes in May 2013, divided by diluted non-GAAP shares outstanding, which is GAAP weighted average shares outstanding less any shares issuable under our convertible senior notes. 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 and comparable understanding of factors and trends affecting our earnings and cash flows.  Refer below for a reconciliation of adjusted EBITDA, free cash flow, and Non-GAAP earnings per share 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. We believe that it is important to view free cash flow as a complement to our reported consolidated financial statements. Management strongly encourages shareholders to review our financial statements and publicly-filed reports in their entirety and not to rely on any single financial measure.

The table below shows the trend of adjusted EBITDA and free cash flow as a percentage of net revenues and Non-GAAP net loss per share for the three and nine months ended September 30, 2013 and 2012 (in thousands, except for percentages and per share amounts):
 
Three Months Ended
September 30,
 
Nine Months Ended
September 30,
 
2013
 
2012
 
2013
 
2012
Net revenues
$
122,685

 
$
98,536

 
$
372,854

 
$
288,847

 
 
 
 
 
 
 
 
Non-GAAP adjusted EBITDA
$
(1,067
)
 
$
(3,136
)
 
$
8,541

 
$
985

EBITDA % of net revenues
(1
)%
 
(3
)%
 
2
 %
 
 %
 
 
 
 
 
 
 
 
Free cash flow
$
(25,717
)
 
$
(23,494
)
 
$
(50,560
)
 
$
(44,009
)
Free cash flow % of net revenues
(21
)%
 
(24
)%
 
(14
)%
 
(15
)%
 
 
 
 
 
 
 
 
Non-GAAP net loss per share
$
(0.24
)
 
$
(0.29
)
 
$
(0.86
)
 
$
(0.84
)

For the three months ended September 30, 2013 and 2012, our adjusted EBITDA was $(1.1) million and $(3.1) million , respectively. For the nine months ended September 30, 2013 and 2012, our adjusted EBITDA was $8.5 million and $1.0 million , respectively. In addition, during the three months ended September 30, 2013 and 2012, we experienced negative free cash flows of $25.7 million and $23.5 million , respectively, and during the nine months ended September 30, 2013 and 2012, we experienced negative free cash flows of $50.6 million and $44.0 million , respectively. Our non-GAAP net loss per share was $0.24 per share and $0.86 for the three and nine months ended September 30, 2013, 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 and positive free cash flows.
 

27

Table of Contents

The following is a reconciliation of adjusted EBITDA, free cash flow, and Non-GAAP earnings/(loss) per share to the most comparable GAAP measure, for the three and nine ended September 30, 2013 and 2012 (in thousands):

Reconciliation of Net Loss to Non-GAAP Adjusted EBITDA
Three Months Ended
 
Nine Months Ended
 
September 30,
 
September 30,
 
2013
 
2012
 
2013
 
2012
Net loss
$
(10,148
)
 
$
(10,478
)
 
$
(34,364
)
 
$
(30,029
)
Add back:
 

 
 

 
 

 
 

Interest expense
3,609

 
148

 
5,684

 
456

Interest and other income, net
(139
)
 
(14
)
 
(181
)
 
(30
)
Benefit from income taxes
(27,944
)
 
(13,401
)
 
(53,658
)
 
(31,008
)
Depreciation and amortization
19,573

 
12,244

 
52,891

 
34,088

Stock-based compensation expense
13,982

 
8,365

 
38,169

 
27,508

Non-GAAP Adjusted EBITDA
$
(1,067
)
 
$
(3,136
)
 
$
8,541

 
$
985

 
Reconciliation of Cash Flow from Operating Activities to Non-GAAP Adjusted EBITDA and Free Cash Flow
Three Months Ended
 
Nine Months Ended
 
September 30,
 
September 30,
 
2013
 
2012
 
2013
 
2012
Net cash provided by/(used in) operating activities
$
309

 
$
(3,568
)
 
$
(71,272
)
 
$
(42,190
)
Add back:
 

 
 

 
 

 
 

Interest expense
3,609

 
148

 
5,684

 
456

Interest and other income, net
(139
)
 
(14
)
 
(181
)
 
(30
)
Benefit from income taxes
(27,944
)
 
(13,401
)
 
(53,658
)
 
(31,008
)
Changes in operating assets and liabilities
19,961

 
11,482

 
123,942

 
68,133

Other adjustments
3,137

 
2,217

 
4,026

 
5,624

Non-GAAP Adjusted EBITDA
(1,067
)
 
(3,136
)
 
8,541

 
985

Less:
 

 
 

 
 

 
 

Purchases of property and equipment, including accrued amounts
(20,343
)
 
(16,628
)
 
(47,044
)
 
(35,391
)
Capitalized technology & development costs
(4,307
)
 
(3,730
)
 
(12,057
)
 
(9,603
)
Free cash flow
$
(25,717
)
 
$
(23,494
)
 
$
(50,560
)
 
$
(44,009
)


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Table of Contents

Reconciliation of Net Loss per Share to Non-GAAP Net Loss per Share
Three Months Ended
 
Nine Months Ended
 
September 30,
 
September 30,
 
2013
 
2012
 
2013
 
2012
GAAP Net loss
$
(10,148
)
 
$
(10,478
)
 
$
(34,364
)
 
$
(30,029
)
Add back interest expense related to:
 

 
 

 
 

 
 

Amortization of debt discount
2,771

 

 
4,172

 

Amortization of debt issuance costs
260

 

 
420

 

0.25% coupon
188

 

 
281

 

Tax effect
(2,046
)
 

 
(2,816
)
 

Non-GAAP net loss
$
(8,975
)
 
$
(10,478
)
 
$
(32,307
)
 
$
(30,029
)
 
 
 
 
 
 
 
 
GAAP diluted shares outstanding
37,814

 
36,062

 
37,541

 
35,691

Add back:
 

 
 

 
 

 
 

Dilutive effect of convertible notes

 

 

 

Non-GAAP shares outstanding
37,814

 
36,062

 
37,541

 
35,691

 
 
 
 
 
 
 
 
GAAP net loss per share
$
(0.27
)
 
$
(0.29
)
 
$
(0.92
)
 
$
(0.84
)
Non-GAAP net loss per share
$
(0.24
)
 
$
(0.29
)
 
$
(0.86
)
 
$
(0.84
)

Off-Balance Sheet Arrangements

We do not have any relationships with unconsolidated entities or financial partnerships, such as entities often referred to as structured finance or special purpose entities, which would have been established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes. In addition, we do not have any undisclosed borrowings or debt and we have not entered into any synthetic leases. We are, therefore, not materially exposed to any financing, liquidity, market or credit risk that could arise if we had engaged in such relationships.

Recent Accounting Pronouncements
 
No new accounting standards have been adopted since our Annual Report on Form 10-K for the fiscal year ended December 31, 2012 was filed. Management does not believe that any new accounting pronouncements not yet effective will have a material impact on our financial statements once adopted.


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Table of Contents

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

Interest Rate and Credit Risk.      We have exposure to interest rate risk that relates primarily to our investment portfolio and our syndicated credit facility. All of our cash equivalents are carried at market value. We may draw funds from our syndicated credit facility under interest rates based on either the Federal Funds Rate or the Adjusted London Interbank Offered Rate (“LIBO rate”). If these rates increase significantly, our costs to borrow these funds will also increase. To date, we have not borrowed any funds under our syndicated credit facility. We do not believe that a 10% change in interest rates would have a significant impact on our interest income and expense, operating results, or liquidity.

Market Risk and Market Interest Risk.      In May 2013, we issued $300.0 million of 0.25% convertible senior notes due May 15, 2018. We carry this instrument at face value less unamortized discount on our balance sheet. Since this instrument bears interest at fixed rates, we have no financial statement risk associated with changes in interest rates. However, the fair value of these instruments fluctuates when interest rates change, and in the case of convertible notes, when the market price of our stock fluctuates.

Inflation.      We do not believe that inflation has had a material effect on our current business, financial condition or results of operations. If our costs were to become subject to significant inflationary pressures, for example, if the cost of our materials or the cost of shipping our products to customers were to incur substantial increases as a result of the rapid rise in the cost of oil, we may not be able to fully offset such higher costs through price increases. Our inability or failure to do so could harm our business, financial condition and results of operations.

ITEM 4. CONTROLS AND PROCEDURES

Our management, with the participation of our Chief Executive Officer and Chief Financial Officer, evaluated the effectiveness of our disclosure controls and procedures as of September 30, 2013. The term “disclosure controls and procedures,” as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, (“Exchange Act”), means controls and other procedures of a company that are designed to ensure that information required to be disclosed by a company in the reports that it files or submits under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed by a company in the reports that it files or submits under the Exchange Act is accumulated and communicated to the company’s management, including its principal executive and principal financial officers, as appropriate to allow timely decisions regarding required disclosure. Management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving their objectives and management necessarily applies its judgment in evaluating the cost-benefit relationship of possible controls and procedures. Based on the evaluation of our disclosure controls and procedures as of September 30, 2013, our Chief Executive Officer and Chief Financial Officer concluded that, as of such date, the Company's disclosure controls and procedures were effective at the reasonable assurance level.

No change in our internal control over financial reporting (as defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) occurred during the quarter ended September 30, 2013 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.


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PART II — OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS

On July 9, 2013, we filed a complaint for alleged patent infringement against Interactive Memories, Inc. (dba “Mixbook”) in the U.S. District Court for the District of Delaware. The complaint asserts infringement of U.S. Patent No. 7,082,227, which claims among other things, a method for personalizing an image-based physical manifestation to conform with a user's preferences for image processing and U.S. Patent No. 7,146,575, which claims among other things, a computer-implemented method for uploading image data to a remote computer and generating a thumbnail associated with the image. The complaint asserts that Mixbook directly or indirectly infringes the patents, and we are seeking an order enjoining Mixbook from further infringing the patents and an award of our damages, costs, expenses and attorneys' fees.

On March 22, 2013, we filed a complaint for damages and injunctive relief against Kodak Imaging Network, Inc. and Eastman Kodak Company (together, “Kodak”) in Shutterfly, Inc. v. Kodak Imaging Network, Inc. and Eastman Kodak Company, Case No. 12-10202 (ALG) in the U.S. Bankruptcy Court, S.D.N.Y. The complaint asserts that by continuing to compete with Shutterfly through its “My Kodak Moments” service Kodak violated the non-competition provisions of the transfer agreement it entered into with us when we purchased the “Kodak Gallery” business. In the complaint, we seek an award of damages and our costs, expenses and attorneys' fees as well as an injunction enjoining Kodak from further violations of the non-competition provisions of the transfer agreement.

On March 7, 2013, CreateAds LLC filed a complaint for alleged patent infringement against us in CreateAds LLC v. Shutterfly, Inc., C.A. No. 13-00384 (GMS) in the U.S. District Court for the District of Delaware. The complaint asserts infringement of U.S. Patent No. 5,535,320, which claim among others things a method of generating a representation of a visual design and applying it to various advertising materials. The complaint asserts that we directly or indirectly infringe the patent without providing any details concerning the alleged infringement, and it seeks unspecified damages. We believe the suit is without merit.


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Table of Contents


ITEM 1A. RISK FACTORS

Risks Related to Our Business and Industry

Our net revenues, operating results and cash requirements are affected by the seasonal nature of our business.

Our business is highly seasonal, with a high proportion of our net revenues, net income and operating cash flows generated during the fourth quarter. For example, we generated more than 50% of our 2012 net revenues in the fourth quarter of 2012, and the net income that we generated during the fourth quarter of 2012 was necessary for us to achieve profitability on an annual basis. In addition, we incur significant additional expenses in the period leading up to the fourth quarter holiday season including expenses related to the hiring and training of temporary workers to meet our seasonal needs, additional inventory and equipment purchases and increased advertising. If we are unable to accurately forecast and respond to consumer demand for our products during the fourth quarter, our financial results, reputation and brands will suffer and the market price of our common stock would likely decline.

We also base our operating expense budgets on expected net revenue trends. A portion of our expenses, such as office, production facility, and various equipment leases and personnel costs, are largely fixed and are based on our expectations of our peak levels of operations. We may be unable to adjust spending quickly enough to offset any unexpected revenue shortfall. Accordingly, any shortfall in net revenues may cause significant variation in operating results in any quarter.

If we are unable to meet our production requirements, our net revenues and results of operations would be harmed.

We believe that we must continue to grow our current production capability to meet our projected net revenue targets. Our capital expenditures were approximately 9% of total net revenues for the year ended December 31, 2012 and approximately 7% of net revenues for the years ended December 31, 2011 and 2010. We anticipate that total capital expenditures for the year ended December 31, 2013 will range from 9.8% to 10.4% of 2013 net revenues. Operational difficulties, such as a significant interruption in the operations of our Fort Mill, South Carolina, Phoenix, Arizona or Elmsford, New York production facilities, could delay production or shipment of our products. Our inability to meet our production requirements could lead to customer dissatisfaction and damage our reputation and brands, which would result in reduced net revenues. Moreover, if the costs of meeting production requirements, including capital expenditures, were to exceed our expectations, our results of operations would be harmed.

In addition, we face significant production risks at peak holiday seasons, including the risk of obtaining sufficient qualified seasonal production personnel. A majority of our workforce during the fourth quarter of 2012 was seasonal, temporary personnel. We have had difficulties in the past finding a sufficient number of qualified seasonal employees, and our failure to obtain qualified seasonal production personnel at any of our production facilities could harm our operations.

Macro economic trends could adversely affect our financial performance.

Our financial performance depends on general economic conditions. The U.S. economy is experiencing a slow economic recovery from a deep recession, concerns about inflation, low consumer confidence, high unemployment rate and other adverse business conditions. Fluctuations in the U.S. economy such as the recent recession could cause, among other adverse business conditions, a prolonged decline in consumer spending and an increase in the cost of labor and materials. Weak economic conditions, low consumer spending and decreased consumption may harm our operating results. Purchases of our products are often discretionary. If the economic climate does not improve, customers or potential customers could delay, reduce or forego their purchases of our products and services, which could impact our business in a number of ways, including lower prices for our products and services and reduced sales. In addition, adverse economic conditions may lead to price increases by our suppliers or increase our operating expenses due to, among others, higher costs of labor, energy, equipment and facilities. A prolonged and slow economic recovery or a renewed recession may also lead to additional restructuring actions and associated expenses. Due to reduced consumer spending and increased competitive pressures in the current economic environment, we may not be able to pass these increased costs on to our customers. The resulting increased expenses and/or reduced income would negatively impact our operating results. If the economic recovery continues to be slow, or if the economy experiences a prolonged period of decelerating or negative growth, our results of operations may be further harmed.