Shutterfly, Inc.
SHUTTERFLY INC (Form: 10-Q, Received: 05/05/2017 16:22:56)
 
UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, DC 20549
Form 10-Q
(Mark One)
ý
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended March 31, 2017
 
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, a smaller reporting company, or an emerging growth company. See definition of “accelerated filer,” “large accelerated filer,” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.
Large accelerated Filer    x
Accelerated Filer    o
Non-accelerated Filer    o
Smaller reporting company o
 
Emerging growth company o
(Do not check if a smaller reporting company)

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

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

1



Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.
Class
 
Outstanding as at May 3, 2017
Common stock, $0.0001 par value per share
 
33,764,721
 

2


TABLE OF CONTENTS

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







3

Table of Contents

PART I FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

SHUTTERFLY, INC.
CONDENSED CONSOLIDATED BALANCE SHEETS
(In thousands, except par value amounts)
(Unaudited)
 
 
March 31, 2017
 
December 31, 2016
ASSETS
 
 
 
Current assets:
 
 
 
Cash and cash equivalents
$
161,515

 
$
289,224

Short-term investments
45,005

 
26,352

Accounts receivable, net
33,243

 
57,365

Inventories
9,664

 
11,751

Prepaid expenses and other current assets
59,941

 
48,084

Total current assets
309,368

 
432,776

Long-term investments
15,903

 
14,479

Property and equipment, net
266,844

 
284,110

Intangible assets, net
39,378

 
43,420

Goodwill
408,975

 
408,975

Other assets
11,597

 
11,816

Total assets
$
1,052,065

 
$
1,195,576

LIABILITIES AND STOCKHOLDERS’ EQUITY
 
 
 
Current liabilities:
 
 
 
Accounts payable
$
14,067

 
$
58,790

Accrued liabilities
79,217

 
138,869

Deferred revenue, current portion
22,225

 
22,929

Total current liabilities
115,509

 
220,588

Convertible senior notes, net
282,527

 
278,792

Other liabilities
112,217

 
137,035

Total liabilities
510,253

 
636,415

Commitments and contingencies (Note 10)

 

Stockholders’ equity:
 
 
 
Common stock, $0.0001 par value; 100,000 shares authorized; 33,729 and 33,637 shares issued and outstanding on March 31, 2017 and December 31, 2016, respectively
3

 
3

Additional paid-in capital
962,558

 
949,864

Accumulated other comprehensive loss
(35
)
 
(32
)
Accumulated deficit
(420,714
)
 
(390,674
)
Total stockholders' equity
541,812

 
559,161

Total liabilities and stockholders' equity
$
1,052,065

 
$
1,195,576

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

4

Table of Contents

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


Three Months Ended

March 31,
 
2017
 
2016
Net revenues
$
191,972

 
$
181,709

Cost of net revenues
116,119

 
108,723

Restructuring
1,240

 

Gross profit
74,613

 
72,986

Operating expenses:
 
 
 

Technology and development
45,955

 
38,269

Sales and marketing
42,887

 
45,842

General and administrative
27,795

 
30,689

Restructuring
7,736

 

Total operating expenses
124,373

 
114,800

Loss from operations
(49,760
)
 
(41,814
)
Interest expense
(5,964
)
 
(5,675
)
Interest and other income, net
189

 
121

Loss before income taxes
(55,535
)
 
(47,368
)
Benefit from income taxes
22,341

 
17,932

Net loss
$
(33,194
)
 
$
(29,436
)
 
 
 
 
Net loss per share - basic and diluted
$
(0.98
)
 
$
(0.85
)
 
 
 
 
Weighted-average shares outstanding - basic and diluted
33,712

 
34,596

 
 
 
 
Stock-based compensation is allocated as follows (Note 2):
 
 
 
Cost of net revenues
$
1,169

 
$
1,224

Technology and development
2,696

 
459

Sales and marketing
3,173

 
4,279

General and administrative
4,467

 
4,188

Restructuring
814

 

 
$
12,319

 
$
10,150


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

5

Table of Contents

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

 
Three Months Ended
 
March 31,
 
2017
 
2016
Net loss
$
(33,194
)
 
$
(29,436
)
Other comprehensive income (loss), net of reclassification adjustments:

 

Unrealized gains (losses) on investments, net
(13
)
 
177

Tax benefit (expense) on unrealized gain (loss) on investments, net
10

 
(69
)
Other comprehensive income (loss), net of tax
(3
)
 
108

Comprehensive loss
$
(33,197
)
 
$
(29,328
)

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


6

Table of Contents

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

 
Three Months Ended
 
March 31,
 
2017
 
2016
Cash flows from operating activities:
 
 
 
Net loss
$
(33,194
)
 
$
(29,436
)
Adjustments to reconcile net loss to net cash used in operating activities:
 

 
 

Depreciation and amortization
23,024

 
22,995

Amortization of intangible assets
4,340

 
6,119

Amortization of debt discount and issuance costs
3,735

 
3,532

Stock-based compensation
11,505

 
10,150

Loss on disposal of property and equipment
172

 
218

Deferred income taxes
2,358

 
3,637

Tax benefit from stock-based compensation

 
5,638

Excess tax benefits from stock-based compensation

 
(6,859
)
Restructuring
7,868

 

Changes in operating assets and liabilities:
 

 
 

Accounts receivable
24,122

 
25,137

Inventories
847

 
1,457

Prepaid expenses and other assets
(11,577
)
 
(26,607
)
Accounts payable
(44,655
)
 
(17,080
)
Accrued and other liabilities
(60,931
)
 
(81,511
)
Net cash used in operating activities
(72,386
)
 
(82,610
)
Cash flows from investing activities:
 

 
 

Purchases of property and equipment
(3,517
)
 
(10,131
)
Capitalization of software and website development costs
(7,602
)
 
(8,639
)
Purchases of investments
(26,304
)
 
(8,026
)
Proceeds from the maturities of investments
6,214

 
11,615

Proceeds from sale of property and equipment
70

 
39

Net cash used in investing activities
(31,139
)
 
(15,142
)
Cash flows from financing activities:
 

 
 

Proceeds from issuance of common stock upon exercise of stock options
117

 
491

Repurchases of common stock
(20,000
)
 
(47,461
)
Excess tax benefits from stock-based compensation

 
6,859

Principal payments of capital lease and financing obligations
(4,301
)
 
(3,772
)
Payment for contingent consideration liabilities

 
(1,313
)
Net cash used in financing activities
(24,184
)
 
(45,196
)
Net decrease in cash and cash equivalents
(127,709
)
 
(142,948
)
Cash and cash equivalents, beginning of period
289,224

 
288,863

Cash and cash equivalents, end of period
$
161,515

 
$
145,915

 
 
 
 
Supplemental schedule of non-cash investing / financing activities:
 
 
 

Net decrease in accrued purchases of property and equipment
$
(1,848
)
 
$
(4,634
)
Net increase (decrease) in accrued capitalized software and website development costs
124

 
(471
)
Stock-based compensation capitalized with software and website development costs
258

 
537


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

7

Table of Contents

SHUTTERFLY, INC.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

Note 1 — The Company and Summary of Significant Accounting Policies

Shutterfly, Inc., (the “Company” or “Shutterfly”) was incorporated in the state of Delaware in 1999 and began its services in December 1999. The Company is the leading online 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 professionally-bound photo books, greeting cards and stationery and calendars. Shutterfly also operates a premier online marketplace for high-quality photographic and video equipment rentals. The Company provides Enterprise services: printing and shipping of variable data print products and formats. The Company's Enterprise brand is called Shutterfly Business Solutions ("SBS") and is referred to as such in this document. The Company is headquartered in Redwood City, California.

Basis of Presentation

The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America ("U.S. GAAP") for interim financial information and, accordingly, do not include all of the information and footnotes required by U.S. GAAP for complete financial statements. The accompanying unaudited condensed consolidated financial statements include the accounts of Shutterfly, Inc. and its wholly owned subsidiaries. In the opinion of management, all adjustments, consisting primarily of normal recurring accruals, considered necessary for a fair statement of the Company’s results of operations for the interim periods reported and of its financial condition as of the date of the interim balance sheet have been included. Operating results for the three months ended March 31, 2017 are not necessarily indicative of the results that may be expected for the year ending December 31, 2017 , or for any other period.

The December 31, 2016 condensed consolidated balance sheet data was derived from audited financial statements, but does not include all disclosures required by U.S. GAAP. These unaudited interim condensed consolidated financial statements should be read in conjunction with the consolidated financial statements and related notes for the year ended December 31, 2016 included in the Company’s Annual Report on Form 10-K.

Recent Accounting Pronouncements
    
In March 2016, the Financial Accounting Standards Board ("FASB") issued Accounting Standards Update ("ASU") 2016-09, Compensation - Stock Compensation (Topic 718): Improvements to Employee Share-Based Payment Accounting ("ASU 2016-09") . The updated guidance changes how companies account for certain aspects of share-based payment awards to employees, including the accounting for income taxes, forfeitures, and statutory tax withholding requirements, as well as classification in the statement of cash flows. The Company adopted ASU 2016-09 beginning January 1, 2017 and the impact of adoption resulted in the following:

The Company recorded approximately $23.2 million of additional deferred tax assets with the corresponding decrease to accumulated deficit related to the prior years' unrecognized excess tax benefits (thus, adoption method was modified retrospective).
The Company recorded a tax benefit of $0.8 million as a discrete item within income tax benefit for the three months ended March 31, 2017 related to the excess tax benefit on stock options, restricted stock and performance share units. Prior to adoption this amount would have been recorded as a reduction of additional paid-in capital. This change could create volatility in the Company’s future effective tax rate.
The Company elected not to change its policy on accounting for forfeitures and will continue to estimate the total number of awards for which the requisite service period will not be rendered.
The Company no longer reclassifies the excess tax benefit from operating activities to financing activities in the statement of cash flows. The Company elected to apply this change in presentation prospectively and thus prior periods have not been adjusted.
The remaining provisions of ASU 2016-09 did not have a material impact on the accompanying condensed consolidated financial statements.

In 2014, the FASB issued new accounting guidance related to revenue recognition. This new standard will replace all current GAAP guidance on this topic and eliminate all industry-specific guidance. The new revenue recognition guidance provides a unified model to determine when and how revenue is recognized. The core principle is that a company should recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration for which the entity expects to be entitled in exchange for those goods or services. In 2016, the FASB issued several amendments to the standard,

8

SHUTTERFLY, INC.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

including principal versus agent considerations when another party is involved in providing goods or services to a customer, the application of identifying performance obligations, and the recognition of expected breakage amounts either proportionally in earnings as redemptions occur or when redemption is remote. As a result, the Company has engaged internal and external resources that are currently evaluating the impact of the new standard on timing and measurement of revenue recognition as well as how current systems and operations will be impacted. While the Company continues to assess all potential impacts of the standard, the Company currently believes there will be an impact related to timing and measurement of flash deal breakage revenue for the consumer business and multiple-element arrangements in connection with our enterprise business. The standard is required to be applied either retrospectively to each prior reporting period presented or retrospectively with the cumulative effect of initially applying it recognized at the date of initial application.  The new standard is effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2017. The Company has not yet selected the transition method.

In February 2016, the FASB issued ASU 2016-02, Leases (Topic 842). The new guidance requires the recognition of lease assets and lease liabilities by lessees for those leases classified as operating leases under previous guidance. The new standard is effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2018 on a modified retrospective basis, and earlier adoption is permitted. The Company is evaluating the impact, if any, of adopting this new accounting guidance on its financial statements.
    
In June 2016, the FASB issued ASU 2016-13,  Financial Instruments-Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments , which requires measurement and recognition of expected credit losses for financial assets held. The new standard is effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2019. Earlier adoption is permitted for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2018. The Company is evaluating the impact of adopting this new accounting guidance on the consolidated financial statements.

In August 2016, the FASB issued ASU 2016-15, Classification of Certain Cash Receipts and Cash Payments. The new guidance clarifies the classification of certain cash receipts and cash payments in the statement of cash flows, including debt prepayment or extinguishment costs, settlement of contingent consideration arising from a business combination, insurance settlement proceeds, and distributions from certain equity method investees. The new standard is effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2017. Early adoption is permitted. The Company is evaluating the impact of adopting this new accounting guidance on the consolidated financial statements.

In January 2017, the FASB issued ASU 2017-04, Intangibles - Goodwill and Other (Topic 350) . The updated guidance simplifies the measurement of goodwill impairment by removing step two of the goodwill impairment test, which requires the determination of the fair value of individual assets and liabilities of a reporting unit. The new guidance requires goodwill impairment to be measured as the amount by which a reporting unit’s carrying value exceeds its fair value; however, the loss recognized should not exceed the total amount of goodwill allocated to that reporting unit. The amendments should be applied on a prospective basis. The new standard is effective for annual or any interim goodwill impairment tests performed in fiscal years beginning after December 15, 2019 with early adoption permitted for interim or annual goodwill impairment tests performed on testing dates after January 1, 2017. The Company is evaluating the impact this new accounting guidance will have on the consolidated financial statements.
    
Note 2 — Stock-Based Compensation

Stock Option Activity

A summary of the Company’s stock option activity for the three months ended March 31, 2017 is as follows (share numbers and aggregate intrinsic values in thousands):

9

SHUTTERFLY, INC.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

 
Number of
Options
Outstanding
 
Weighted
Average
Exercise
Price
 
Weighted
Average Remaining
Contractual
Term (Years)
 
Aggregate
Intrinsic
Value
Balance as of December 31, 2016
950

 
$
46.58

 
 
 
 
Granted
456

 
45.04

 
 
 
 
Exercised
(5
)
 
26.02

 
 
 
 
Forfeited, cancelled or expired

 

 
 
 
 
Balance as of March 31, 2017
1,401

 
$
46.17

 
6.2
 
$
3,102

Options vested and expected to vest as of March 31, 2017
1,291

 
$
46.26

 
6.1
 
$
2,748

Options vested as of March 31, 2017
95

 
$
32.39

 
3.1
 
$
1,622

 
During the three months ended March 31, 2017 , the Company granted options to purchase an aggregate of 456,000 shares of common stock with an estimated weighted-average grant-date fair value of $12.05 . The total intrinsic value of options exercised during the three months ended March 31, 2017 and 2016 was $0.1 million and $0.4 million , respectively. Net cash proceeds from the exercise of stock options for the three months ended March 31, 2017 and 2016 were $0.1 million and $0.5 million , respectively.

Valuation of Stock Options

The Company estimates the fair value of each option award on the date of grant using the Black-Scholes option-pricing model. The Company calculates volatility using an average of its historical and implied volatilities as it had sufficient public trading history to cover the entire expected term. The expected term of options gives consideration to historical exercises, post-vest cancellations and the options contractual term. The risk-free rate for the expected term of the option is based on the U.S. Treasury Constant Maturity at the time of grant. The assumptions used to value options granted during the three months ended March 31, 2017 are as follows (there were no option awards granted during the three months ended March 31, 2016):
 
Three Months Ended
 
March 31, 2017
Dividend yield

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



Restricted Stock Unit Activity

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

A summary of the Company’s RSU activity for the three months ended March 31, 2017 , is as follows (share numbers in thousands):

10

SHUTTERFLY, INC.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

 
Number of
Units
Outstanding
 
Weighted
Average
Grant Date
Fair Value
Awarded and unvested as of December 31, 2016
2,834

 
$
43.52

Granted
591

 
46.77

Vested
(515
)
 
42.91

Forfeited
(124
)
 
41.96

Awarded and unvested as of March 31, 2017
2,786

 
$
44.39

RSUs expected to vest as of March 31, 2017
2,253

 
 

Employee stock-based compensation expense recognized in the three months ended March 31, 2017 and 2016 , was calculated based on awards ultimately expected to vest and has been reduced for estimated forfeitures. Forfeitures are estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates.

At March 31, 2017 , the Company had $94.7 million of total unrecognized stock-based compensation expense, net of estimated forfeitures, related to stock options, RSUs and PBRSUs that will be recognized over a weighted-average period of approximately three years.

Note 3 — Net Loss Per Share

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

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

A summary of the net loss per share for the three months ended March 31, 2017 and 2016 is as follows (in thousands, except per share amounts):
 
Three Months Ended
 
March 31,
 
2017
 
2016
Net loss per share:
 
 
 
Numerator
 
 
 
Net loss
$
(33,194
)
 
$
(29,436
)
Denominator for basic and diluted net loss per share
 

 
 
Weighted-average common shares outstanding
33,712

 
34,596

Net loss per share - basic and diluted
$
(0.98
)
 
$
(0.85
)

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

 
Three Months Ended
 
March 31,
 
2017
 
2016
Stock options and restricted stock units
3,961

 
3,649


Note 4 — Investments


11

SHUTTERFLY, INC.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

At March 31, 2017 and December 31, 2016 , the estimated fair value of short-term and long-term investments classified as available-for-sale are as follows (in thousands):
 
 
March 31, 2017
 
 
Amortized Cost
 
Gross Unrealized Gains
 
Gross Unrealized Losses
 
Estimated Fair Value
Short-term investments
 
 
 
 
 
 
 
 
Corporate debt securities
 
$
25,221

 
$
3

 
$
(22
)
 
$
25,202

Agency securities
 
7,658

 
1

 
(4
)
 
7,655

Commercial paper
 
8,474

 

 

 
8,474

U.S. Government securities
 
3,674

 

 

 
3,674

Total short-term investments
 
$
45,027

 
$
4

 
$
(26
)
 
$
45,005

Long-term investments
 
 
 
 
 
 
 
 
Corporate debt securities
 
$
9,383

 
$
2

 
$
(13
)
 
$
9,372

Agency securities
 
4,225

 

 
(18
)
 
4,207

U.S. Government securities
 
2,331

 

 
(7
)
 
2,324

Total long-term investments
 
$
15,939

 
$
2

 
$
(38
)
 
$
15,903


 
 
December 31, 2016
 
 
Amortized Cost
 
Gross Unrealized Gains
 
Gross Unrealized Losses
 
Estimated Fair Value
Short-term investments
 
 
 
 
 
 
 
 
Corporate debt securities
 
$
13,371

 
$
2

 
$
(12
)
 
$
13,361

Agency securities
 
7,957

 
6

 

 
7,963

Commercial paper
 
1,727

 

 

 
1,727

U.S. Government securities
 
3,298

 
3

 

 
3,301

Total short-term investments
 
$
26,353

 
$
11

 
$
(12
)
 
$
26,352

Long-term investments
 
 
 
 
 
 
 
 
Corporate debt securities
 
$
6,208

 
$
1

 
$
(20
)
 
$
6,189

Agency securities
 
5,359

 

 
(20
)
 
5,339

U.S. Government securities
 
2,956

 
1

 
(6
)
 
2,951

Total long-term investments
 
$
14,523

 
$
2

 
$
(46
)
 
$
14,479


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

The following table summarizes the contractual maturities of the Company's investments as of March 31, 2017 and December 31, 2016 (in thousands):
 
March 31, 2017
 
December 31, 2016
One year or less
$
45,005

 
$
26,352

One year through three years
15,903

 
14,479

 
$
60,908

 
$
40,831


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


12

SHUTTERFLY, INC.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

Note 5 — Fair Value Measurement

Cash Equivalents and Investments

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

The following table summarizes, by major security type, the Company's cash equivalents and investments that are measured at fair value on a recurring basis and are categorized using the fair value hierarchy (in thousands):
 
Total Estimated Fair Value as of
 
March 31, 2017
 
December 31, 2016
 
Cash Equivalents
 
Investments
 
Cash Equivalents
 
Investments
Level 1 Securities:
 
 
 
 
 
 
 
Money market funds
$
25,619

 
$

 
$
808

 
$

Level 2 Securities:
 
 
 
 
 
 
 
Corporate debt securities
1,000

 
34,574

 
2,309

 
19,550

Agency securities

 
11,862

 

 
13,302

Commercial Paper
8,204

 
8,474

 
6,694

 
1,727

U.S. Government securities

 
5,998

 

 
6,252

Total cash equivalents and investments
$
34,823

 
$
60,908

 
$
9,811

 
$
40,831


Convertible Senior Notes

As of March 31, 2017 , the fair value of the convertible senior notes, which was determined based on inputs that are observable in the market or that could be derived from, or corroborated with, observable market data, including our stock price, interest rates and credit spread (Level 2) were as follows (in thousands):
 
Total Estimated Fair Value as of
 
March 31, 2017
 
December 31, 2016
Convertible senior notes
$
293,022

 
$
290,436


The carrying value of other financial instruments, including accounts receivable, accounts payable and other payables, approximates fair value due to their short maturities.


13

SHUTTERFLY, INC.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

Note 6 — Balance Sheet Components

Prepaid Expenses and Other Current Assets
 
March 31, 2017
 
December 31, 2016
 
(in thousands)
Intra-period income tax asset
$
24,683

 
$

Prepaid service contracts - current portion
10,936

 
11,114

Manufacturing partners receivable
4,936

 
11,739

Other prepaid expenses and current assets
19,386

 
25,231

 
$
59,941

 
$
48,084


Intra-period income tax asset represents the cumulative income tax benefit recorded as of the balance sheet date, which will offset against taxes payable or become a component of deferred taxes on a full year basis.

Property and Equipment, Net
 
March 31, 2017
 
December 31, 2016
 
(in thousands)
Manufacturing equipment
$
179,357

 
$
182,484

Computer equipment and software
178,549

 
177,525

Capitalized software and website development costs
141,138

 
134,427

Buildings under build-to-suit leases
56,468

 
56,468

Leasehold improvements
22,144

 
22,007

Rental equipment
18,956

 
18,786

Furniture and fixtures
11,053

 
11,057

 
607,665

 
602,754

Less: Accumulated depreciation and amortization
(340,821
)
 
(318,644
)
Net property and equipment
$
266,844

 
$
284,110

 
Included within manufacturing equipment is approximately $89.9 million of capital lease obligations for various pieces of manufacturing facility equipment as of both March 31, 2017 and December 31, 2016 . Accumulated depreciation of assets under capital lease totaled $29.2 million at March 31, 2017 compared to $25.1 million at December 31, 2016 .

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

Depreciation and amortization expense totaled $23.0 million for both the three months ended March 31, 2017 and 2016 .

Included in property and equipment is approximately $10.0 million and $14.3 million of assets in construction as of March 31, 2017 and December 31, 2016 , respectively, the majority of which relates to internal-use software.


14

SHUTTERFLY, INC.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

Accrued Liabilities
 
March 31, 2017
 
December 31, 2016
 
(in thousands)
Accrued compensation
$
21,443

 
$
17,066

Capital lease obligations, current portion
16,168

 
16,092

Accrued production costs
13,363

 
38,755

Accrued marketing expenses
8,022

 
23,839

Accrued consulting
5,847

 
8,643

Accrued income and sales tax
3,761

 
19,846

Accrued other
10,613

 
14,628

 
$
79,217

 
$
138,869

 
Other Liabilities
 
March 31, 2017
 
December 31, 2016
 
(in thousands)
Financing obligations
$
54,966

 
$
55,355

Capital lease obligations, non-current portion
46,164

 
50,213

Deferred tax liability

 
20,446

Deferred revenue, non-current portion
6,882

 
7,303

Other liabilities
4,205

 
3,718

 
$
112,217

 
$
137,035


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

Note 7 — 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 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

15

SHUTTERFLY, INC.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

immediately preceding calendar quarter is greater than or equal to 130% of the conversion price on each applicable trading day;
during the five business day period after any ten consecutive trading day period (the “Notes Measurement Period”) in which the "trading price" (as the term is defined in the Indenture) per $1,000 principal amount of notes for each trading day of such Notes Measurement Period was less than 98% of the product of the last reported sale price of the Company's common stock on such trading day and the conversion rate on each such trading day;
upon the occurrence of specified corporate events; or
at any time on or after December 15, 2017 until the close of business on the second scheduled trading immediately preceding the maturity date.
As of March 31, 2017 , 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):
 
March 31, 2017
 
December 31, 2016
Liability component:
 
 
 
Principal
$
300,000

 
$
300,000

Less: debt issuance costs, debt discount, net of amortization
(17,473
)
 
(21,208
)
Net carrying amount
$
282,527

 
$
278,792

 
 
 
 
Equity component (1)
$
63,510

 
$
63,510


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

The following table sets forth total interest expense recognized related to the Notes (in thousands):
 
Three Months Ended
 
March 31,
 
2017
 
2016
0.25% coupon
$
187

 
$
188

Amortization of debt issuance costs
341

 
323

Amortization of debt discount
3,394

 
3,209

 
$
3,922

 
$
3,720

 
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

16

SHUTTERFLY, INC.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

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 8 — Share Repurchase Program

On October 24, 2012, the Company's Board of Directors conditionally authorized and the Audit Committee subsequently approved a share repurchase program for up to $60.0 million of the Company's common stock. As of March 31, 2017 , the Company's Board of Directors has approved increases to the program on the following dates:
On February 6, 2014, the Company's Board of Directors approved an increase of $100.0 million in addition to any amounts repurchased as of that date.
On February 9, 2015, the Company's Board of Directors approved an increase of $300.0 million in addition to any amounts repurchased as of that date.
On April 21, 2016, the Company's Board of Directors approved an increase of $100.0 million in addition to any amounts repurchased as of that date.
The share repurchase program is subject to prevailing market conditions and other considerations; does not require the Company to repurchase any dollar amount or number of shares; and may be suspended or discontinued at any time. The share repurchase authorization, which was effective immediately, permits the Company to effect repurchases for cash from time to time through open market, privately negotiated or other transactions, including pursuant to trading plans established in accordance with Rules 10b5-1 and 10b-18 of the Securities Exchange Act of 1934, as amended, or by a combination of such methods.
The following table provides information about our repurchase of shares of our common stock for fiscal years 2014, 2015 , 2016 , and 2017 :
Period (1)
 
Total Number of Shares Purchased
 
Average Price Paid per Share
 
Total Dollar Value Spent on Repurchases (in thousands)
2014 Repurchases
 
1,961,085

 

$45.29

 

$88,815

2015 Repurchases (2)
 
4,907,675

 

$43.99

 

$215,911

2016 Repurchases
 
2,524,752

 

$44.55

 

$112,488

2017 Repurchases to date (3)
 
429,583

 

$46.56

 

$20,000


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

(2)
The Company entered into an accelerated share repurchase ("ASR") in the second quarter of 2015 under which a prepayment of $75.0 million was made. Final settlement of the ASR occurred on August 3, 2015, resulting in the delivery to the Company

17

SHUTTERFLY, INC.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

of 0.8 million shares of the Company’s common stock and a return of cash for the remaining amount not settled in shares of $38.2 million . In total, approximately 0.8 million shares of common stock were repurchased under the ASR for $36.8 million , resulting in an average price paid per share of $46.49 under the ASR.

(3)
Represents repurchases for the three months ended March 31, 2017 .

Note 9 — Segment Reporting

The Company reports segment information based on its internal reporting used by management for making decisions and assessing performance as the source of its reportable segments.
    
The Chief Operating Decision Maker ("CODM") function uses gross profit to evaluate the performance of the segments and allocate resources. Management considers gross margin to be the appropriate metric to evaluate and compare the ongoing performance of each reportable segment as it is the level at which direct costs associated with the performance of the segment are monitored. Cost of net revenues for the Consumer segment consists of costs directly attributable to the production of personalized products for all of our brands, including direct materials (the majority of which consists of paper, ink, and photo book covers), shipping charges, packing supplies, distribution and fulfillment activities, third-party costs for photo-based merchandise, payroll and related expenses for direct labor and customer service, rent for production facilities, and depreciation of production equipment and facilities where we are the deemed owner. Cost of net revenues also includes third-party software or patents licensed, as well as the amortization of acquired developed technology, capitalized website and software development costs, and patent royalties, when those costs are directly attributable to the production of products. Cost of net revenues also includes certain costs associated with inventory markdowns and restructuring activities. Cost of net revenues for the SBS segment consists of costs which are direct and incremental to the SBS business. These include production costs of SBS products, such as materials, labor and printing costs and costs associated with third-party production of goods. They also include shipping costs and indirect overhead.

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

In addition to the above reportable segments, the Company has a corporate category that includes activities that are not directly attributable or allocable to a specific segment. This category consists of stock-based compensation expense and amortization of intangible assets.
The Company’s segment results for the three months ended March 31, 2017 and 2016 were as follows (dollars in thousands):

18

SHUTTERFLY, INC.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

 
Three Months Ended
 
March 31,
 
2017
 
2016
Consumer
 
 
 
Net revenues
$
160,645

 
$
155,381

Cost of net revenues
89,854

 
86,337

Restructuring
1,240

 

Gross profit
$
69,551

 
$
69,044

Gross profit as a percentage of net revenues
43
%
 
44
%
 
 
 
 
Shutterfly Business Solutions (SBS)
 
 
 
Net revenues
$
31,327

 
$
26,328

Cost of net revenues
23,838

 
19,710

Gross profit
$
7,489

 
$
6,618

Gross profit as a percentage of net revenues
24
%
 
25
%

 
 
 
Corporate
 
 
 
Net revenues
$

 
$

Cost of net revenues
2,427

 
2,676

Gross profit
$
(2,427
)
 
$
(2,676
)

 
 
 
Consolidated
 
 
 
Net revenues
$
191,972

 
$
181,709

Cost of net revenues
116,119

 
108,723

Restructuring
1,240

 

Gross profit
$
74,613

 
$
72,986

Gross profit as a percentage of net revenues
39
%
 
40
%

Note 10 — Commitments and Contingencies

Indemnifications

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

Contingencies

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

Syndicated Credit Facility

On November 22, 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, U.S. Bank and Citibank, N.A. (“the Banks”). The Credit Agreement was subsequently amended on May 10, 2013. As part of the expansion in May 2013, Bank of America, N.A. and

19

SHUTTERFLY, INC.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

Morgan Stanley Bank, N.A. joined the syndicate. Details regarding the Credit Agreement is discussed in our Annual Report on Form 10-K for the fiscal year ended December 31, 2016.

On June 10, 2016, the Company renewed the Credit Agreement with the Banks. As part of this renewal, Fifth Third Bank, Silicon Valley Bank, U.S. Bank and Citibank, N.A. left the syndicate and SunTrust Bank and BMO Harris Bank N.A. joined the syndicate. The Credit Agreement is for five years and provides for a $200.0 million senior secured revolving credit facility. As part of the renewal, the Company amended the Credit Agreement by and among the Company and the Banks to increase the Leverage Ratio (as defined in the Credit Agreement) to be maintained by the Company to be at or below 3.50 to 1.00 for the fiscal quarter ended June 30, 2016 through March 31, 2017, at or below 3.25 to 1.00 for the fiscal quarter ending June 30, 2017 through March 31, 2018, and at or below 3.00 to 1.00 for the fiscal quarter ended June 30, 2018 and thereafter. Unchanged from the initial credit agreement, the Credit Agreement contains customary representations and warranties, affirmative and negative covenants, and events of default. Also, the Company may not permit the ratio of its Consolidated EBITDA for any period of four consecutive fiscal quarters to its interest and rental expense and the amount of scheduled principal payments on long-term debt, for the same period, to be less than 2.50 to 1.00. As of March 31, 2017 , the Company is in compliance with these covenants.

Amounts repaid under the Facility may be reborrowed. The revolving loan facility matures on the fifth anniversary of its closing and is payable in full upon maturity. The Company intends to use the new Facility from time to time for general corporate purposes, working capital and potential acquisitions.

Legal Matters

The Company is subject to the various legal proceedings and claims discussed below as well as certain other legal proceedings and claims that have not been fully resolved and that have arisen in the ordinary course of business. Although adverse decisions (or settlements) may occur in one or more of these cases, it is not possible to estimate the possible loss or losses from each of these cases. The final resolution of these lawsuits, individually or in the aggregate, is not expected to have a material adverse effect on the Company's business, financial position or results of operations. Cases that previously were disclosed may no longer be described because of rulings in the case, settlements, changes in our business or other developments rendering them, in our judgment, no longer material to our business, financial position or results of operations.

The State of Delaware v. Shutterfly, Inc.

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

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

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.



20

SHUTTERFLY, INC.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

Note 11 — Restructuring

2017 Restructuring Plan

During the first quarter of 2017, the Board of Directors approved, committed to and initiated a plan to significantly simplify the Consumer business during 2017 ("2017 Restructuring Plan"). As part of the plan, the Company is reinvesting in Tiny Prints as its premium cards & stationery brand and is creating a Tiny Prints boutique on a dedicated tab on Shutterfly.com. The new Shutterfly Wedding Store will be the focus of the Company’s wedding strategy, including a premium Wedding Paper Divas-branded stationery collection. The MyPublisher brand will be retired in favor of the industry leading Shutterfly Photo Books category and BorrowLenses will undertake a strategic review for possible sale. The Company expects these actions will be completed by the end of third quarter of 2017, and the Tiny Prints, Wedding Paper Divas, and MyPublisher legacy websites will shut down. The Company seeks to retain as many customers and as much revenue as possible while migrating customers from the legacy websites to Shutterfly.com. The total estimated restructuring costs associated with the 2017 Restructuring Plan will range from $15.0 to $20.0 million and will impact our cost of net revenues and operating expenses line items within our condensed consolidated statement of operations as these costs are incurred. Any changes to the estimates of executing the 2017 Restructuring Plan will be reflected in our future results of operations.

2015 Restructuring Plan

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

Restructuring Activity

The following table summarizes the restructuring costs recognized during the three months ended March 31, 2017:
 
 
2017 Restructuring
 
2015 Restructuring
 
 
 
 
Property and equipment
 
Employee costs
 
Inventory
 
Other costs
 
Property and equipment
 
Total
Balance as of January 1, 2017 [1]
 
$

 
$

 
$

 
$

 
$
1,602

 
$
1,602

Restructuring and other charges
 
3,638

 
3,798

 
1,240

 
119

 
181

 
8,976

Cash payments
 

 
(1,102
)
 

 
(6
)
 
(157
)
 
(1,265
)
Non-cash adjustments [2]
 
(3,638
)
 
(814
)
 
(1,240
)
 
(14
)
 

 
(5,706
)
Balance as of March 31, 2017 [1]
 
$

 
$
1,882

 
$

 
$
99

 
$
1,626

 
$
3,607

 
 
 
 
 
 
 
 
 
 
 
 
 
[1] The balances as of March 31, 2017 and December 31, 2016 are recorded in accrued liabilities.
[2]  Non-cash adjustments include depreciation and amortization of disposed property and equipment (primarily capitalized software development costs and manufacturing equipment) and intangible assets, inventory write-off, stock-based compensation, and other non-cash costs incurred as part of the restructuring.


21

SHUTTERFLY, INC.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

Note 12 — Subsequent Event

On April 18, 2017, the Company's Board of Directors approved an increase to repurchase up to $140.0 million in addition to amounts authorized to date. The share repurchase authorization, which is effective immediately, permits the Company to effect repurchases for cash from time to time through open market, privately negotiated or other transactions, including pursuant to trading plans established in accordance with Rules 10b5-1 and 10b-18 of the Securities Exchange Act of 1934, as amended, or by a combination of such methods. The share repurchase program is subject to prevailing market conditions and other considerations; does not require Shutterfly to repurchase any dollar amount or number of shares; and may be suspended or discontinued at any time.


22


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, restructuring activities, technology initiatives, the seasonality of and growth of our business, the impact on us of general economic conditions, trends in key metrics such as total number of customers, total number of orders, and average order value, our capital expenditures for 2017, 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, our manufacturing capabilities, our new production facilities, effective tax rates, outstanding convertible senior notes, stock repurchase program 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,” “seek,” “continue,” “should,” “would,” “could,” “will,” or “may,” or the negative of these terms or other comparable terminology. Forward-looking statements involve risks and uncertainties. Our actual results and the timing of events could differ materially from those anticipated in our forward-looking statements as a result of many factors, including but not limited to, 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, 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 and implement innovative, new products and services on a timely and cost-effective basis, including our next generation Shutterfly platform; consumer acceptance of our products 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 and maintain 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
 
Shutterfly, Inc. was incorporated in Delaware in 1999. In September 2006, we completed our initial public offering and our common stock is listed on the NASDAQ Global Select Market under the symbol “SFLY.” Our principal corporate offices are located in Redwood City, California.

We are the leading online manufacturer and retailer of high-quality personalized products and services. 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.

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 trusted premium brands are:

Shutterfly leads the market in digital personalized photo products and services. Shutterfly helps our customers turn their precious memories into lasting keepsakes with award-winning professionally-bound photo books, personalized holiday cards, announcements, invitations and stationery, as well as custom home decor products and unique photo gifts. Our online photo service helps our customers stay connected with family and friends, empowering them to do more with their pictures by expressing themselves in extraordinary ways.

Tiny Prints is a leading premium online cards and stationery boutique, offering stylish announcements, invitations and personal stationery for every occasion. Tiny Prints has grown from a tiny self-funded company specializing in unique baby stationery to a leading online destination for stylish stationery, for every occasion. Customers (celebrities and top designers alike) seek us out for our fresh designs, premium paper and exceptional customer service.

23

Table of Contents


Wedding Paper Divas offers stylish and personalized save the dates, wedding invitations, thank you cards, bridal invitations and more which are all designed by leading artists in the industry.

MyPublisher is where our customers can create custom professionally-bound photo books, share great memories and tell their stories using their own photos.

BorrowLenses is a premier online market place for high-quality photographic and video equipment rentals.

Groovebook is a mobile photo book app subscription service that sends customers a keepsake book of their mobile photos on a periodic basis.

We generate the majority of our revenues by producing and selling a variety of products such as greeting and stationery cards, professionally-bound photo books, personalized calendars, home décor, statement gifts, other photo-based merchandise and high-quality prints. We manufacture most of these items in our Fort Mill, South Carolina; Shakopee, Minnesota; and Tempe, Arizona production facilities. By operating 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 products that are currently manufactured for us by third parties, such as calendars, mugs, ornaments, candles, pillows and blankets.  

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 approximately 50% of our total net revenues during our fiscal fourth quarter. Our operations and financial performance depend on general economic conditions in the United States, consumer sentiment, and the levels of consumer discretionary spending.  We closely monitor these economic measures as their trends are indicators of the health of the overall economy and are some of the key external factors that impact our business.

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

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

In order to successfully execute our strategies, we require a talented leadership team. As a result, we intend to continue our focus to attract, retain, and grow our team; and to build continuity and pursue executional excellence in our daily operations everywhere. By providing our employees with a great place to work, we believe that we continue to strengthen our high performance culture. In December 2015, our President and Chief Executive Officer and our Senior Vice President and Chief Operating Officer announced that they were leaving the Company on February 19, 2016. In May 2016, we hired Christopher North as our President and Chief Executive Officer. Mr. North joined us from Amazon UK where he most recently served as UK Managing Director of Amazon EU Sarl.

During the first quarter of 2017, the Board of Directors approved, committed to and initiated a plan to significantly simplify the Consumer business during 2017. As part of the plan, we are reinvesting in Tiny Prints as its premium cards & stationery brand and is creating a Tiny Prints boutique on a dedicated tab on Shutterfly.com. The new Shutterfly Wedding Store will be the focus of the Company’s wedding strategy, including a premium Wedding Paper Divas-branded stationery collection. The MyPublisher brand will be retired in favor of the industry leading Shutterfly Photo Books category and BorrowLenses will undertake a strategic review for possible sale. We expect these actions will be completed by the end of third quarter of 2017, and the Tiny Prints, Wedding Paper Divas, and MyPublisher legacy websites will shut down. We expect the plan will result in future benefits to operating expenses; however, the expected benefits to operating expenses are not measurable at this point. We seek to retain as many customers and as much revenue as possible while migrating customers from the legacy websites to Shutterfly.com. The total estimated restructuring costs associated with the 2017 Restructuring Plan will range from $15.0 to $20.0 million and will impact our cost of net revenues and operating expenses line items within our condensed consolidated statement of operations as these costs are incurred. Any changes to the estimates of executing the 2017 Restructuring Plan will be reflected in our future results of operations.


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Basis of Presentation

Net Revenues.       Our net revenues are comprised of sales generated from Consumer and SBS segments.
 
Consumer. Our Consumer revenues include sales from all of our brands and are derived from the sale of a variety of products, such as greeting and stationery cards, professionally-bound photo books, personalized calendars, home décor, personalized gifts, high quality prints, and other photo-based merchandise, and the related shipping revenues as well as rental revenue from our BorrowLenses brand. Revenue from advertising displayed on our websites is also included in Consumer revenues.
 
SBS.      Our SBS revenues are primarily from the printing and shipping of marketing and variable data print products and formats. We continue to focus our efforts in expanding our presence in this market.

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

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

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

Total Number of Orders.      We closely monitor total number of orders as a leading indicator of net revenue trends. We recognize net revenues associated with an order when the products have been shipped and all other revenue recognition criteria have been met. Orders are typically processed and shipped in approximately three business days after a customer places an order. Total number of orders has increased on an annual basis for each year since 2000.
 
Average Order Value.      Average order value ("AOV") is Consumer net revenues for a given period divided by the total number of customer orders recorded during that same period. AOV is impacted by product sales mix and pricing and promotional strategies, including our promotions and competitor promotional activity. As a result, our AOV may fluctuate on a quarterly and annual basis.

Our SBS segment revenues are generated from the printing and shipping of variable data print products and formats.     

We believe the analysis of these metrics and others described under "Non-GAAP Financial Measures" provides us with important information on our overall net revenue trends and operating results. Fluctuations in these metrics are not unusual and no single factor is determinative of our net revenues and operating results.

Cost of Net Revenues.    Our cost of net revenues is split between our Consumer and SBS segments and our Corporate category.

Consumer.     Cost of net revenues for the Consumer segment consists of costs directly attributable to the production of personalized products for all of our brands, including direct materials (the majority of which consists of paper, ink, and photo book covers), shipping charges, packing supplies, distribution and fulfillment activities, third-party costs for photo-based merchandise, payroll and related expenses for direct labor and customer service, rent for production facilities, and depreciation of production equipment and facilities where we are the deemed owner. Cost of net revenues also includes third-party software or patents licensed, as well as the amortization of acquired developed technology, capitalized website and software development costs, and patent royalties, when those costs are directly attributable

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to the production of products. Cost of net revenues also includes certain costs associated with facility closures and inventory markdowns as part of restructuring activities.

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

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

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

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 user data, as well as amortization of software used to operate such hardware. Technology and development expense also includes co-location, power and bandwidth costs. Technology and development expense does not include costs that are directly attributable to the production of products.

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

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

Interest Expense.    Interest expense consists of interest on our convertible senior notes arising from amortization of debt discount, amortization of debt issuance costs and our 0.25% coupon payment, costs associated with our five-year syndicated credit facility that was renewed in June 2016, and costs associated with our capital leases and build-to-suit lease financing obligations.

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

Income Taxes.    We account for income taxes under the liability method. Under this method, deferred tax assets and liabilities are determined based on the difference between the financial statement and tax basis of assets and liabilities. We are subject to taxation in the United States and Israel.

Critical Accounting Policies and Estimates

The discussion and analysis of our financial condition and results of operations are based upon our unaudited condensed consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses. On an on-going basis, we evaluate our critical accounting policies and estimates. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. Our critical accounting policies and estimates are discussed in our Annual Report on Form 10-K for the fiscal year ended December 31, 2016.

Recent Accounting Pronouncements


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

Results of Operations

The following table presents the components of our statement of operations as a percentage of net revenues:
 
Three Months Ended
 
March 31,
 
2017
 
2016
Net revenues
100
 %
 
100
 %
Cost of net revenues
60
 %
 
60
 %
Restructuring
1
 %
 
 %
Gross profit
39
 %
 
40
 %
Operating expenses:


 


Technology and development
24
 %
 
21
 %
Sales and marketing
22
 %
 
25
 %
General and administrative
15
 %
 
17
 %
Restructuring
4
 %
 
 %
Total operating expenses
65
 %
 
63
 %
Loss from operations
(26
)%
 
(23
)%
Interest expense
(3
)%
 
(3
)%
Interest and other income, net
 %
 
 %
Loss before income taxes
(29
)%
 
(26
)%
Benefit from income taxes
12
 %
 
10
 %
Net loss
(17
)%
 
(16
)%


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Comparison of the Three Month Periods Ended March 31, 2017 and 2016
 
 
Three Months Ended March 31,
 
 
2017
 
2016
 
$ Change
 
% Change
 
 
(in thousands)
Consolidated
 
 
 
 
 
 
 
 
Net revenues
 
$
191,972

 
$
181,709

 
$
10,263

 
6
%
Cost of net revenues
 
116,119

 
108,723

 
7,396

 
7
%
Restructuring
 
1,240

 

 
1,240

 
100
%
Gross profit
 
$
74,613

 
$
72,986

 
$
1,627

 
2
%
Gross profit as a percentage of net revenues
 
39
%
 
40
%
 
 
 
 
Gross profit excluding restructuring as a percentage of net revenues
 
40
%
 
40
%
 
 
 
 

Net revenues increased $10.3 million , or 6% , for the three months ended March 31, 2017 as compared to the same period in 2016 . Cost of net revenues increased $7.4 million , or 7% , for the three months ended March 31, 2017 as compared to the same period in 2016 . As a percentage of net revenues, cost of net revenues remained flat at 60% in the three months ended March 31, 2017 and 2016 . Also impacting gross profit in the three months ended March 31, 2017 was $1.2 million of restructuring charges. Gross margin decreased to 39% in the three months ended March 31, 2017 from 40% in the same period in 2016 primarily due to the impact of the restructuring activities related to inventory markdowns.

 
 
Three Months Ended March 31,
 
 
2017
 
2016
 
$ Change
 
% Change
 
 
(in thousands)
Consumer
 
 
 
 
 
 
 
 
Net revenues
 
$
160,645

 
$
155,381

 
$
5,264

 
3
%
Cost of net revenues
 
89,854

 
86,337

 
3,517

 
4
%
Restructuring
 
1,240

 

 
1,240

 
100
%
Gross profit
 
$
69,551

 
$
69,044

 
$
507

 
1
%
Gross profit as a percentage of net revenues
 
43
%
 
44
%
 
 
 
 
Gross profit excluding restructuring as a percentage of net revenues
 
44
%
 
44
%
 
 
 
 
 
 
Three Months Ended March 31,
 
 
2017
 
2016
 
Change
 
% Change
 
 
(in thousands, except AOV amounts)
Key Consumer Metrics
 
 
Total Customers
 
3,365

 
3,322

 
43

 
1
 %
Total Number of Orders
 
5,535

 
5,541

 
(6
)
 
 %
Average order value (AOV)
 
$
29.02

 
$
28.04

 
$
0.98

 
3
 %

Consumer Segment

Consumer net revenues increased $5.3 million , or 3% , in the three months ended March 31, 2017 compared to the same period in 2016 .  The increase in Consumer net revenues was primarily a result of increased sales in the Home Décor and Personalized Gifts, photo books, and mobile categories. This was partially offset by continued declines from non-Shutterfly brands. AOV increased 3% in the three months ended March 31, 2017 compared to the same period in 2016 driven by favorable product mix.

Consumer cost of net revenues increased $3.5 million , or 4% , for the three months ended March 31, 2017 as compared to the same period in 2016 . The increase in cost of net revenues is primarily due to increased Consumer net revenues.

In the three months ended March 31, 2017, $1.2 million of restructuring charges impacted gross margin in the consumer segment. These restructuring charges were related to the write-off of inventories which were determined to be obsolete during the Consumer segment restructuring. Consumer gross margin excluding restructuring was 44% in the three months ended March 31, 2017, flat with the same period in 2016.


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Three Months Ended March 31,
 
 
2017
 
2016
 
$ Change
 
% Change
 
 
(in thousands)
Shutterfly Business Solutions (SBS)
 
 
 
 
 
 
 
 
Net revenues
 
$
31,327

 
$
26,328

 
$
4,999

 
19
%
Cost of net revenues
 
23,838

 
19,710

 
4,128

 
21
%
Gross profit
 
$
7,489

 
$
6,618

 
$
871

 
13
%
Gross profit as a percentage of net revenues
 
24
%
 
25
%
 
 
 
 

SBS Segment

SBS net revenues increased $5.0 million , or 19% , in the three months ended March 31, 2017 compared to the same period in 2016 . The increase in SBS net revenues came both from higher revenue volumes with existing customers and our ability to execute on personalized print and digital communications at scale.

SBS cost of net revenues increased $4.1 million , or 21% , for the three months ended March 31, 2017 as compared to the same period in 2016 . SBS gross margin decreased to 24% in the three months ended March 31, 2017 from 25% in the same period in 2016 . The decrease in SBS gross margin is primarily due to increased costs associated with expansion of projects with our existing customers.

 
 
Three Months Ended March 31,
 
 
2017
 
2016
 
$ Change
 
% Change
 
 
(in thousands)
Corporate
 
 
 
 
 
 
 
 
Net revenues
 
$

 
$

 
$

 
 %
Cost of net revenues
 
2,427

 
2,676

 
(249
)
 
(9
)%
Gross profit
 
$
(2,427
)
 
$
(2,676
)
 
$
249

 
(9
)%

Corporate Segment

Corporate cost of net revenues decreased $0.2 million , or 9% in the three months ended March 31, 2017 compared to the same period in 2016 . The decrease in corporate cost of net revenues was a result of slight decreases in stock-based compensation and amortization of intangible assets.
 
Three Months Ended March 31,
 
2017
 
2016
 
$ Change
 
% Change
 
(in thousands)
Technology and development
$
45,955

 
$
38,269

 
$
7,686

 
20
 %
Percentage of net revenues
24
%
 
21
%
 

 

Sales and marketing
$
42,887

 
$
45,842

 
$
(2,955
)
 
(6
)%
Percentage of net revenues
22
%
 
25
%
 

 

General and administrative
$
27,795

 
$
30,689

 
$
(2,894
)
 
(9
)%
Percentage of net revenues
15
%
 
17
%
 

 

Restructuring
$
7,736

 
$

 
$
7,736

 
100
 %
Percentage of net revenues
4
%
 
%
 

 


Our technology and development expense increased $7.7 million , or 20% , for the three months ended March 31, 2017 , compared to the same period in 2016 as the Company continues to invest in mobile, the consumer platform consolidation and our SBS Business. As a percentage of net revenues, technology and development increased to 24% in the three months ended March 31, 2017 from 21% in the three months ended March 31, 2016 . The overall increase in expense was primarily due to an increase of $4.1 million in professional fees, an increase in stock-based compensation expense of $2.2 million , an increase of $1.5 million in personnel and related costs due to increased headcount, and an increase of $1.3 million in facilities costs primarily resulting from

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additional co-location expenses and network and database operations. These factors were partially offset by a decrease of $0.6 million in depreciation and amortization expense and by an increase of $0.8 million in software and website development costs capitalized.

At March 31, 2017 , headcount in technology and development increased by 3% compared to March 31, 2016 , reflecting our strategic focus on increasing 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 March 31, 2017 , we capitalized $7.2 million in eligible salary and consultant costs, including $0.2 million of stock-based compensation expense, associated with software developed or obtained for internal use, compared to $6.6 million capitalized in the three months ended March 31, 2016 , which included $0.5 million of stock-based compensation expense.

Our sales and marketing expense decreased $3.0 million , or 6% , in the three months ended March 31, 2017 compared to the same period in 2016 . As a percentage of net revenues, total sales and marketing expense decreased to 22% in the three months ended March 31, 2017 from 25% in the three months ended March 31, 2016 . The decrease in our sales and marketing expense was due to a decrease of $1.6 million in depreciation and amortization expense due to full amortization of intangibles acquired in prior acquisitions in the second half of 2016. There was also a decrease of stock-based compensation of $1.1 million and a decrease of $0.8 million in integrated marketing campaigns, marketing partnerships, and professional fees due to the efficiencies resulting from the Consumer segment restructuring. This was partially offset by an increase of $0.6 million in personnel costs.

Our general and administrative expense decreased $2.9 million , or 9% , in the three months ended March 31, 2017 as compared to the same period in 2016 . As a percentage of net revenues, general and administrative expense decreased to 15% in the three months ended March 31, 2017 from 17% in the three months ended March 31, 2016 . The decrease in general and administrative expense was primarily due to a decrease of $2.4 million in personnel related costs driven by severance costs for the former Chief Executive Officer incurred in the three months ended March 31, 2016. There was also a decrease of $1.0 million in depreciation and amortization expense and a decrease of $0.3 million in professional fees. This was partially offset by an increase of $0.6 million in facilities costs and an increase of $0.3 million in stock-based compensation expense.

In the three months ended March 31, 2017, there was $7.7 million of restructuring charges within operating expenses. These restructuring charges primarily consist of $3.8 million in depreciation expense of disposed assets and $3.8 million in severance, retention and other employee costs.

 
Three Months Ended March 31,
 
2017
 
2016
 
Change
 
(in thousands)
Interest expense
$
(5,964
)
 
$
(5,675
)
 
$
(289
)
Interest and other income, net
189

 
121

 
68


Interest expense consists of interest on our convertible senior notes, amortization of the issuance costs associated with our convertible senior notes and credit facility, capital leases, and our financing obligation associated with our production facilities in Fort Mill, South Carolina; Shakopee, Minnesota; and Tempe, Arizona. Interest expense was $6.0 million for the three months ended March 31, 2017 compared to $5.7 million during the same period a year ago. This increase in interest expense was primarily driven by an increases in interest expense from our convertible debt and capital leases compared to prior year.
 
Three Months Ended March 31,
 
2017
 
2016
 
(in thousands)
Benefit from income taxes
$
22,341

 
$
17,932

Effective tax rate
40
%
 
38
%

We recorded an income tax benefit of $22.3 million and $17.9 million for the three months ended March 31, 2017 and 2016, respectively. Our effective tax rate was 40% for the three months ended March 31, 2017 , compared to 38% for the three months ended March 31, 2016 . Factors that impacted the effective tax rate include the federal research and development credit, limitations on executive compensation, excess tax benefits from stock compensation and the domestic activities production deduction.


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Liquidity and Capital Resources

At March 31, 2017 , we had $161.5 million of cash and cash equivalents and $60.9 million of investments, primarily agency securities and corporate bonds. To supplement our overall liquidity position, in May 2013 we issued $300.0 million of 0.25% convertible senior notes due May 15, 2018. We also have access to a five-year senior secured syndicated credit facility expiring in June 2021 to provide up to $200.0 million in additional capital resources. As of March 31, 2017 , no amounts have been drawn against this facility.

Below is our cash flow activity for the three months ended March 31, 2017 :
 
Three Months Ended March 31,
 
2017
 
2016
 
(in thousands)
Consolidated Statements of Cash Flows Data:
 
 
 
Purchases of property and equipment
$
(3,517
)
 
$
(10,131
)
Capitalization of software and website development costs
(7,602
)
 
(8,639
)
Cash flows used in operating activities
(72,386
)
 
(82,610
)
Cash flows used in investing activities
(31,139
)
 
(15,142
)
Cash flows used in financing activities
(24,184
)
 
(45,196
)

We anticipate that our current cash balance and cash generated from operations will be sufficient to meet our strategic and working capital requirements, lease obligations, share repurchase program, technology development projects, and coupon payments for our 0.25% convertible senior notes for at least the next twelve months. Whether these resources are adequate to meet our liquidity needs beyond that period will depend on our growth, operating results, and the capital expenditures required to meet possible increased demand for our products. If we require additional capital resources to grow our business internally or to acquire complementary technologies and businesses at any time in the future, we may seek to sell additional debt or additional equity. The sale of additional equity or convertible debt could result in significant dilution to our stockholders. Financing arrangements may not be available to us, or may not be in amounts or on terms acceptable to us.

We anticipate that total 2017 capital expenditures will be approximately 6% to 7% of 2017 net revenues. These expenditures will be used to make developments to Shutterfly Photos, to improve mobile capabilities, to develop the SBS platform, to purchase technology and equipment to support the growth in our business, to increase our production capacity, and to simplify the process of creating and purchasing personalized products and by continuing to expand the range of products we offer our customers. This range of capital expenditures is not outside the ordinary course of our business or materially different from how we have expanded our business in the past.

The following table shows total capital expenditures including amounts accrued but not yet paid by category for the three months ended March 31, 2017 and 2016 :
 
Three Months Ended March 31,
 
2017
 
2016
 
(in thousands)
Technology equipment and software
$
1,447

 
$
3,386

Percentage of total capital expenditures
15
%
 
25
%
Manufacturing equipment, building improvements and other
221

 
2,111

Percentage of total capital expenditures
2
%
 
15
%
Capitalized technology and development costs
7,727

 
8,168

Percentage of total capital expenditures
83
%
 
60
%
Total capital expenditures
$
9,395

 
$
13,665

Total capital expenditures percentage of net revenues
5
%
 
8
%

Operating Activities. For the three months ended March 31, 2017 , net cash used in operating activities was $72.4 million , primarily due to our net loss of $33.2 million and the net change in operating assets and liabilities of $92.2 million . Net cash used in operating activities was adjusted for non-cash items including $23.0 million of depreciation and amortization expense, $11.5

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million of stock-based compensation expense, $7.9 million of non-cash restructuring, $4.3 million of amortization of intangible assets, $3.7 million for amortization of debt discount and $2.4 million provision from deferred income taxes.

For the three months ended March 31, 2016, net cash used in operating activities was $82.6 million, primarily due to our net loss of $29.4 million and the net change in operating assets and liabilities of $98.6 million. Net cash used in operating activities was adjusted for non-cash items including $23.0 million of depreciation and amortization expense, $10.2 million of stock-based compensation expense, $6.1 million of amortization of intangible assets, $3.5 million for amortization of debt discount and $3.6 million benefit from deferred income taxes.

Investing Activities. For the three months ended March 31, 2017 , net cash used in investing activities was $31.1 million . We used $3.5 million for capital expenditures for computer and network hardware to support our website infrastructure and information technology systems and production equipment for our manufacturing and production operations. We also used $7.6 million for capitalized software and website development and $26.3 million to purchase investments. This was partially offset by proceeds from the maturities and sales of investments of $6.2 million and proceeds from sale of property and equipment of $0.1 million .

For the three months ended March 31, 2016, net cash used in investing activities was $15.1 million.  We used $10.1 million for capital expenditures for computer and network hardware to support our website infrastructure and information technology systems and production equipment for our manufacturing and production operations, $8.6 million for capitalized software and website development, and $8.0 million to purchase investments. This was partially offset by proceeds from the sale of investments of $11.6 million.

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

For the three months ended March 31, 2016, net cash used in financing activities was $45.2 million. We used $47.5 million to repurchase shares of our common stock. We also used $3.8 million for payments of capital leases and financing obligations and $1.3 million for payment of contingent consideration. This was partially offset by $6.9 million in excess tax benefit from stock-based compensation expense and $0.5 million of proceeds from the issuance of common stock from the exercise of stock options.

Non-GAAP Financial Measures

Regulation G, conditions for use of Non-Generally Accepted Accounting Principles ("Non-GAAP") financial measures, and other SEC regulations define and prescribe the conditions for use of certain Non-GAAP financial information. We closely monitor four financial measures, Non-GAAP net loss, Non-GAAP net loss per share, adjusted EBITDA and adjusted EBITDA minus capital expenditures which meet the definition of Non-GAAP financial measures. We define Non-GAAP net loss and Non-GAAP net loss per share as net loss and net loss per share excluding restructuring, respectively. We define adjusted EBITDA as earnings before interest, taxes, depreciation, amortization, stock-based compensation, and restructuring.  Adjusted EBITDA minus capital expenditures is defined as adjusted EBITDA less purchases of property and equipment and capitalization of software and website development costs.  This was previously referred to as "free cash flow" prior to the fourth quarter of 2016. Management believes these Non-GAAP financial measures reflect an additional way of viewing our profitability and liquidity that, when viewed with our GAAP results, provides a more complete understanding of factors and trends affecting our earnings and cash flows.  Refer below for a reconciliation of Non-GAAP net loss, Non-GAAP net loss per share, adjusted EBITDA and adjusted EBITDA minus capital expenditures 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 adjusted EBITDA minus capital expenditures 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.


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The table below shows the trend of Non-GAAP net loss, Non-GAAP net loss per share, adjusted EBITDA and adjusted EBITDA minus capital expenditures as a percentage of net revenues for the three months ended March 31, 2017 and 2016 (in thousands except per share amounts):
 
Three Months Ended
 
March 31,
 
2017
 
2016
Net revenues
$
191,972

 
$
181,709

GAAP net loss
$
(33,194
)
 
$
(29,436
)
GAAP net loss % of net revenues
(17
)%
 
(16
)%
GAAP net loss per share
$
(0.98
)
 
$
(0.85
)
 
 
 
 
Non-GAAP net loss
$
(28,166
)
 
$
(29,436
)
Non-GAAP net loss % of net revenues
(15
)%
 
(16
)%
 
 
 
 
Non-GAAP net loss per share
$
(0.84
)
 
$
(0.85
)
 
 
 
 
Non-GAAP adjusted EBITDA
$
(1,915
)
 
$
(2,550
)
Non-GAAP adjusted EBITDA % of net revenues
(1
)%
 
(1
)%
 
 
 
 
Non-GAAP adjusted EBITDA minus capital expenditures
$
(11,310
)
 
$
(16,215
)
Non-GAAP adjusted EBITDA minus capital expenditures % of net revenues
(6
)%
 
(9
)%

For the three months ended March 31, 2017 and 2016 , our Non-GAAP net loss was $28.2 million and $29.4 million , respectively. In addition, during the three months ended March 31, 2017 and 2016 , Non-GAAP net loss per share was $0.84 and $0.85 , respectively.

For the three months ended March 31, 2017 and 2016 , our adjusted EBITDA loss was $1.9 million and $2.6 million , respectively. In addition, during the three months ended March 31, 2017 and 2016 , adjusted EBITDA minus capital expenditures was $11.3 million and $16.2 million , respectively.

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

The following is a reconciliation of Non-GAAP net loss, Non-GAAP net loss per share, adjusted EBITDA and adjusted EBITDA minus capital expenditures to the most comparable GAAP measure, for the three months ended March 31, 2017 and 2016 (in thousands except per share amounts):

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Table of Contents

   Reconciliation of Net Loss to Non-GAAP Net Loss
 
Three Months Ended
 
March 31,
 
2017
 
2016
GAAP net loss
$
(33,194
)
 
$
(29,436
)
Restructuring
8,976

 

Tax benefit restructuring impact
(3,948
)
 

Non-GAAP net loss
$
(28,166
)
 
$
(29,436
)
 
 
 
 
GAAP diluted shares outstanding
33,712

 
34,596

Non-GAAP diluted shares outstanding
33,712

 
34,596

 
 
 
 
GAAP net loss per share
$
(0.98
)
 
$
(0.85
)
Non-GAAP net loss per share
$
(0.84
)
 
$
(0.85
)

Reconciliation of Net Loss to Non-GAAP Adjusted EBITDA
 
 
 
 
Three Months Ended
 
March 31,
 
2017
 
2016
Net loss
$
(33,194
)
 
$
(29,436
)
Add back:
 

 
 

Interest expense
5,964

 
5,675

Interest and other income, net
(189
)
 
(121
)
Benefit from income taxes
(22,341
)
 
(17,932
)