Shutterfly, Inc.
SHUTTERFLY INC (Form: 10-Q, Received: 10/31/2017 17:08:25)
 
UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, DC 20549
Form 10-Q
(Mark One)
ý
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended September 30, 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 October 27, 2017
Common stock, $0.0001 par value per share
 
32,832,644
 

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)
 
 
September 30, 2017
 
December 31, 2016
ASSETS
 
 
 
Current assets:
 
 
 
Cash and cash equivalents
$
55,959

 
$
289,224

Short-term investments
44,977

 
26,352

Accounts receivable, net
61,468

 
57,365

Inventories
12,057

 
11,751

Prepaid expenses and other current assets
81,322

 
48,084

Total current assets
255,783

 
432,776

Long-term investments
11,739

 
14,479

Property and equipment, net
269,145

 
284,110

Intangible assets, net
32,544

 
43,420

Goodwill
408,975

 
408,975

Other assets
28,751

 
11,816

Total assets
$
1,006,937

 
$
1,195,576

LIABILITIES AND STOCKHOLDERS’ EQUITY
 
 
 
Current liabilities:
 
 
 
Convertible senior notes, current
$
290,157

 
$

Accounts payable
25,098

 
58,790

Accrued liabilities
90,596

 
138,869

Deferred revenue, current portion
22,794

 
22,929

Total current liabilities
428,645

 
220,588

Convertible senior notes, net

 
278,792

Other liabilities
121,522

 
137,035

Total liabilities
550,167

 
636,415

Commitments and contingencies (Note 10)

 

Stockholders’ equity:
 
 
 
Common stock, $0.0001 par value; 100,000 shares authorized; 32,798 and 33,637 shares issued and outstanding on September 30, 2017 and December 31, 2016, respectively
3

 
3

Additional paid-in capital
985,098

 
949,864

Accumulated other comprehensive income (loss)
828

 
(32
)
Accumulated deficit
(529,159
)
 
(390,674
)
Total stockholders' equity
456,770

 
559,161

Total liabilities and stockholders' equity
$
1,006,937

 
$
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
 
Nine Months Ended

September 30,
 
September 30,
 
2017
 
2016
 
2017
 
2016
Net revenues
$
195,443

 
$
187,328

 
$
596,447

 
$
572,998

Cost of net revenues
131,108

 
117,754

 
365,432

 
336,069

Restructuring
39

 

 
1,475

 

Gross profit
64,296

 
69,574

 
229,540

 
236,929

Operating expenses:
 
 
 

 
 
 
 

Technology and development
39,614

 
43,284

 
124,968

 
122,866

Sales and marketing
33,331

 
41,903

 
119,205

 
135,284

General and administrative
23,894

 
26,181

 
79,200

 
83,462

Capital lease termination

 

 
8,098

 

Restructuring
3,278

 

 
15,491

 

Total operating expenses
100,117

 
111,368

 
346,962

 
341,612

Loss from operations
(35,821
)
 
(41,794
)
 
(117,422
)
 
(104,683
)
Interest expense
(6,699
)
 
(5,726
)
 
(18,617
)
 
(17,062
)
Interest and other income, net
253

 
130

 
687

 
379

Loss before income taxes
(42,267
)
 
(47,390
)
 
(135,352
)
 
(121,366
)
Benefit from income taxes
16,660

 
18,235

 
53,713

 
46,290

Net loss
$
(25,607
)
 
$
(29,155
)
 
$
(81,639
)
 
$
(75,076
)
 
 
 
 
 
 
 
 
Net loss per share - basic and diluted
$
(0.78
)
 
$
(0.86
)
 
$
(2.45
)
 
$
(2.19
)
 
 
 
 
 
 
 
 
Weighted-average shares outstanding - basic and diluted
32,878

 
33,932

 
33,363

 
34,235

 
 
 
 
 
 
 
 
Stock-based compensation is allocated as follows (Note 2):
 
 
 
 
 
 
 
Cost of net revenues
$
1,041

 
$
1,131

 
$
3,284

 
$
3,436

Technology and development
2,512

 
2,725

 
7,388

 
5,696

Sales and marketing
2,864

 
3,664

 
9,017

 
11,697

General and administrative
4,319

 
4,694

 
13,021

 
12,459

Restructuring

 

 
814

 

 
$
10,736

 
$
12,214

 
$
33,524

 
$
33,288


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
 
Nine Months Ended
 
September 30,
 
September 30,
 
2017
 
2016
 
2017
 
2016
Net loss
$
(25,607
)
 
$
(29,155
)
 
$
(81,639
)
 
$
(75,076
)
Other comprehensive income (loss), net of reclassification adjustments:
 
 
 
 
 
 
 
Unrealized gains (losses) on investments, net
21

 
(59
)
 
(7
)
 
149

Tax benefit (expense) on unrealized gains (losses) on investments, net
(8
)
 
23

 
8

 
(57
)
Unrealized gains on cash flow hedges
1,402

 

 
1,402

 

Tax expense on unrealized gains on cash flow hedges
(543
)
 

 
(543
)
 

Other comprehensive income (loss), net of tax
872

 
(36
)
 
860

 
92

Comprehensive loss
$
(24,735
)
 
$
(29,191
)
 
$
(80,779
)
 
$
(74,984
)

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)

 
Nine Months Ended
 
September 30,
 
2017
 
2016
Cash flows from operating activities:
 
 
 
Net loss
$
(81,639
)
 
$
(75,076
)
Adjustments to reconcile net loss to net cash used in operating activities:
 

 
 

Depreciation and amortization
66,367

 
69,314

Amortization of intangible assets
11,770

 
15,744

Amortization of debt discount and issuance costs
11,365

 
10,747

Stock-based compensation
32,710

 
33,288

Loss on disposal of property and equipment
705

 
378

Deferred income taxes
(8,607
)
 
5,786

Tax benefit from stock-based compensation

 
263

Excess tax benefits from stock-based compensation

 
(886
)
Restructuring
11,636

 

Changes in operating assets and liabilities:
 

 
 

Accounts receivable
(4,103
)
 
10,463

Inventories
(1,782
)
 
2,115

Prepaid expenses and other assets
(34,064
)
 
(61,113
)
Accounts payable
(35,819
)
 
(15,105
)
Accrued and other liabilities
(49,198
)
 
(66,493
)
Net cash used in operating activities
(80,659
)
 
(70,575
)
Cash flows from investing activities:
 

 
 

Purchases of property and equipment
(22,960
)
 
(43,733
)
Capitalization of software and website development costs
(25,977
)
 
(27,136
)
Purchases of investments
(44,381
)
 
(21,891
)
Proceeds from the maturities of investments
28,456

 
25,070

Proceeds from sale of property and equipment
21,232

 
14,071

Net cash used in investing activities
(43,630
)
 
(53,619
)
Cash flows from financing activities:
 

 
 

Proceeds from issuance of common stock upon exercise of stock options
626

 
1,935

Repurchases of common stock
(80,000
)
 
(90,837
)
Excess tax benefits from stock-based compensation

 
886

Principal payments of capital lease and financing obligations
(24,813
)
 
(15,128
)
Payment for contingent consideration liabilities

 
(1,313
)
Payment of credit agreement issuance costs
(4,789
)
 

Net cash used in financing activities
(108,976
)
 
(104,457
)
Net decrease in cash and cash equivalents
(233,265
)
 
(228,651
)
Cash and cash equivalents, beginning of period
289,224

 
288,863

Cash and cash equivalents, end of period
$
55,959

 
$
60,212

 
 
 
 
Supplemental schedule of non-cash investing / financing activities:
 
 
 

Net increase (decrease) in accrued purchases of property and equipment
4,263

 
(1,274
)
Net decrease in accrued capitalized software and website development costs
(161
)
 
(97
)
Stock-based compensation capitalized with software and website development costs
1,084

 
1,322

Property and equipment acquired under capital leases
18,224

 
23,946


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”) was incorporated in the state of Delaware in 1999 and is the leading online manufacturer and retailer of high-quality personalized products and services. Shutterfly, Inc. brands include Shutterfly, where photos come to life in photo books, gifts, and cards and stationery–with premium offerings in its Tiny Prints boutique–as well as wedding invitations and stationery for every step of the wedding planning process; BorrowLenses, the premier online marketplace for photographic and video equipment rentals; and Groovebook, an iOS and Android app and subscription service that prints up to 100 mobile device photos in a Groovebook and mails it to customers every month. 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 and cards and stationery. 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" or "the Enterprise business") 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 and nine months ended September 30, 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.

During the second quarter of 2017, the Company took advantage of an opportunity to complete the upgrade of its color printer fleet. The benefits of the upgrade are improved quality, increased throughput and automation, and lower consumable costs. There are three pieces of this transaction as follows:
Purchase of leased equipment from an existing vendor for $21.6 million ;
Sale of the purchased leased equipment to HP, Inc. ("HP") for $20.5 million ; and
Lease of new equipment from HP

In the purchase of the existing leased equipment, the difference between the payment of $21.6 million and the fair value of the asset resulted in an $8.1 million capital lease termination charge (separate line item in the accompanying condensed consolidated statement of operations). The purchased equipment assets were recorded on the balance sheet at fair value of $12.9 million . The subsequent sale of the equipment to HP for $20.5 million , resulted in the removal of the equipment assets and a capital lease incentive of $7.9 million to be amortized over the new lease term. Lastly, the Company leased new equipment from HP which upgrades most of the Company's remaining color fleet to HP's high-end printers.

Recent Accounting Pronouncements
    
In August 2017, the Financial Accounting Standards Board ("FASB") issued Accounting Standards Update ("ASU") 2017-12, Derivatives and Hedging (Topic 815): Targeted Improvements to Accounting for Hedging Activities ("ASU 2017-12") . The Company early adopted ASU 2017-12 during the third quarter of fiscal 2017 with no impact to the financial statements as the Company did not have existing hedging relationships or other derivative instruments in place within the scope of Accounting Standards Codification (“ASC”) 815, Derivatives and Hedging, prior to the third quarter of fiscal 2017.

In March 2016, the FASB issued 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

8

SHUTTERFLY, INC.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

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 (adoption method was modified retrospective).
The Company recorded a tax benefit of $1.0 million as a discrete item within income tax benefit for the nine months ended September 30, 2017 related to the excess tax benefit on stock options, restricted stock and performance share units (the recorded tax benefit for the three months ended September 30, 2017 is not significant). 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 therefore, 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, 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 proportionally in earnings as redemptions occur. As a result, the Company has engaged internal and external resources that are currently finalizing the evaluation of 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 finalize its assessment of all potential impacts of the standard, the Company has identified that there will be an impact related to timing and measurement of breakage revenue for the consumer business and for one of the Company's significant multiple-element arrangements in connection with the Enterprise business. As it relates to timing and measurement of breakage revenue, the Company will recognize the expected breakage amounts as revenue in proportion to the pattern of rights exercised by the customer, rather than the current method of recognizing breakage revenue when the Company believes the redemption is remote. As it relates to timing and measurement of one of the Company's multiple-element arrangements in connection with the Enterprise business, deferred revenue is currently recognized over the stated term of the contract. Upon adoption of the new standard, revenue for these particular arrangements will be recognized over a period of time that is shorter than the stated contract term, as these arrangements do not contain substantive termination penalties throughout the entire stated contract term. The standard is required to be applied using either of two methods: (1) retrospectively to each prior reporting period presented (“full retrospective method”) or (2) retrospectively with the cumulative effect of initially applying the new revenue guidance recognized as an adjustment to accumulated deficit at the date of initial application and providing certain additional disclosures (“modified retrospective method”). The new standard is effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2017. The Company will adopt the new revenue recognition guidance in the first quarter of fiscal 2018 and expects to adopt the standard pursuant to the modified retrospective 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 of adopting this new accounting guidance on the consolidated financial statements.
    
In June 2016, the FASB issued ASU 2016-13,  Financial Instruments-Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments , which requires measurement and recognition of expected credit losses for financial assets held. The new standard is effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2019. Earlier adoption is permitted for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2018. The Company is evaluating the impact of adopting this new accounting guidance on the consolidated financial statements.


9

SHUTTERFLY, INC.
NOTES TO UNAUDITED CONDENSED 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 nine months ended September 30, 2017 is as follows (share numbers and aggregate intrinsic values in thousands):
 
Number of
Options
Outstanding
 
Weighted
Average
Exercise
Price
 
Weighted
Average Remaining
Contractual
Term (Years)
 
Aggregate
Intrinsic
Value
Balance as of December 31, 2016
950

 
$
46.58

 
 
 
 
Granted
614

 
45.68

 
 
 
 
Exercised
(28
)
 
22.46

 
 
 
 
Forfeited, cancelled or expired
(1
)
 
9.38

 
 
 
 
Balance as of September 30, 2017
1,535

 
$
46.69

 
5.9
 
$
2,862

Options vested and expected to vest as of September 30, 2017
1,415

 
$
46.77

 
5.8
 
$
2,537

Options vested as of September 30, 2017
354

 
$
45.87

 
5.1
 
$
1,038

 
During the nine months ended September 30, 2017 , the Company granted options to purchase an aggregate of 614,000 shares of common stock with an estimated weighted-average grant-date fair value of $12.23 . The total intrinsic value of options exercised during the three months ended September 30, 2017 and 2016 was $0.1 million and $1.9 million , respectively. The total intrinsic value of options exercised during the nine months ended September 30, 2017 and 2016 was $0.8 million and $2.6 million , respectively.

Net cash proceeds from the exercise of stock options for the three months ended September 30, 2017 and 2016 were $0.1 million and $1.2 million , respectively. Net cash proceeds from the exercise of stock options for the nine months ended September 30, 2017 and 2016 were $0.6 million and $1.9 million , respectively.

Valuation of Stock Options

The Company estimates the fair value of each option award on the date of grant using the Black-Scholes option-pricing model. The Company calculates volatility using an average of its historical and implied volatilities as it has sufficient public trading history 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 nine months ended September 30, 2017 and 2016 are as follows (there were no option awards granted during the three months ended September 30, 2017 and 2016 , respectively):

10

SHUTTERFLY, INC.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

 
Nine Months Ended
 
September 30,
 
2017
 
2016
Dividend yield

 

Annual risk-free rate of return
1.9
%
 
1.2
%
Expected volatility
29.8
%
 
32.9
%
Expected term (years)
4.1

 
4.1


Restricted Stock Unit Activity

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

A summary of the Company’s RSU activity for the nine months ended September 30, 2017 , is as follows (share numbers in thousands):
 
Number of
Units
Outstanding
 
Weighted
Average
Grant Date
Fair Value
Awarded and unvested as of December 31, 2016
2,834

 
$
43.52

Granted
791

 
47.25

Vested
(798
)
 
44.19

Forfeited
(347
)
 
43.61

Awarded and unvested as of September 30, 2017
2,480

 
$
44.48

RSUs expected to vest as of September 30, 2017
2,064

 
 

Employee stock-based compensation expense recognized in the three and nine months ended September 30, 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 September 30, 2017 , the Company had $79.0 million of total unrecognized stock-based compensation expense, net of estimated forfeitures, related to stock options, RSUs and PBRSUs that will be recognized over a weighted-average period of approximately two years.

Note 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 and nine months ended September 30, 2017 and 2016 is as follows (in thousands, except per share amounts):

11

SHUTTERFLY, INC.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

 
Three Months Ended
 
Nine Months Ended
 
September 30,
 
September 30,
 
2017
 
2016
 
2017
 
2016
Net loss per share:
 
 
 
 
 
 
 
Numerator
 
 
 
 
 
 
 
Net loss
$
(25,607
)
 
$
(29,155
)
 
$
(81,639
)
 
$
(75,076
)
Denominator for basic and diluted net loss per share
 

 
 
 
 
 
 
Weighted-average common shares outstanding
32,878

 
33,932

 
33,363

 
34,235

Net loss per share - basic and diluted
$
(0.78
)
 
$
(0.86
)
 
$
(2.45
)
 
$
(2.19
)

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
 
Nine Months Ended
 
September 30,
 
September 30,
 
2017
 
2016
 
2017
 
2016
Stock options and restricted stock units
4,070

 
3,923

 
4,026

 
3,666


Note 4 — Investments

At September 30, 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):
 
 
September 30, 2017
 
 
Amortized Cost
 
Gross Unrealized Gains
 
Gross Unrealized Losses
 
Estimated Fair Value
Short-term investments
 
 
 
 
 
 
 
 
Corporate debt securities
 
$
32,464

 
$
1

 
$
(17
)
 
$
32,448

Agency securities
 
5,602

 

 
(8
)
 
5,594

Commercial paper
 
3,989

 

 

 
3,989

U.S. Government securities
 
2,950

 

 
(4
)
 
2,946

Total short-term investments
 
$
45,005

 
$
1

 
$
(29
)
 
$
44,977

Long-term investments
 
 
 
 
 
 
 
 
Corporate debt securities
 
$
8,923

 
$
1

 
$
(8
)
 
$
8,916

Agency securities
 
2,211

 

 
(13
)
 
2,198

U.S. Government securities
 
629

 

 
(4
)
 
625

Total long-term investments
 
$
11,763

 
$
1

 
$
(25
)
 
$
11,739



12

SHUTTERFLY, INC.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

 
 
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 September 30, 2017 and 2016 and no impairments were recorded during the nine months ended September 30, 2017 and 2016. The Company had no material realized gains or losses during the nine months ended September 30, 2017 and 2016.

The following table summarizes the contractual maturities of the Company's investments as of September 30, 2017 and December 31, 2016 (in thousands):
 
September 30, 2017
 
December 31, 2016
One year or less
$
44,977

 
$
26,352

One year through three years
11,739

 
14,479

 
$
56,716

 
$
40,831


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

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 September 30, 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):

13

SHUTTERFLY, INC.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

 
Total Estimated Fair Value as of
 
September 30, 2017
 
December 31, 2016
 
Cash Equivalents
 
Investments
 
Cash Equivalents
 
Investments
Level 1 Securities:
 
 
 
 
 
 
 
Money market funds
$
29,487

 
$

 
$
808

 
$

Level 2 Securities:
 
 
 
 
 
 
 
Corporate debt securities

 
41,364

 
2,309

 
19,550

Agency securities

 
7,792

 

 
13,302

Commercial Paper

 
3,989

 
6,694

 
1,727

U.S. Government securities

 
3,571

 

 
6,252

Total cash equivalents and investments
$
29,487

 
$
56,716

 
$
9,811

 
$
40,831


Derivative Assets

As of September 30, 2017 , the fair value of the interest-rate swap agreements, which were determined based on an income-based valuation model that takes into account the contract terms as well as multiple observable market inputs such as LIBOR-based yield curves, futures, volatilities and basis spreads (Level 2), were as follows (the Company had no outstanding derivative financial instruments as of December 31, 2016):
 
Total Estimated Fair Value as of
 
September 30, 2017
Derivative assets
$
1,402


Convertible Senior Notes

As of September 30, 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
 
September 30, 2017
 
December 31, 2016
Convertible senior notes
$
294,699

 
$
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.

14

SHUTTERFLY, INC.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

Note 6 — Balance Sheet Components

Prepaid Expenses and Other Current Assets
 
September 30, 2017
 
December 31, 2016
 
(in thousands)
Intra-period income tax asset
$
45,095

 
$

Prepaid service contracts - current portion
10,774

 
11,114

Manufacturing partners receivable
458

 
11,739

Other prepaid expenses and current assets
24,995

 
25,231

 
$
81,322

 
$
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
 
September 30, 2017
 
December 31, 2016
 
(in thousands)
Manufacturing equipment
$
189,188

 
$
182,484

Computer equipment and software
187,424

 
177,525

Capitalized software and website development costs
144,771

 
134,427

Buildings under build-to-suit leases
56,468

 
56,468

Leasehold improvements
20,039

 
22,007

Rental equipment
18,998

 
18,786

Furniture and fixtures
7,708

 
11,057

 
624,596

 
602,754

Less: Accumulated depreciation and amortization
(355,451
)
 
(318,644
)
Property and equipment, net
$
269,145

 
$
284,110

 
Included within manufacturing equipment is approximately $90.4 million and $89.9 million of capital lease obligations for various pieces of manufacturing facility equipment as of September 30, 2017 and December 31, 2016 , respectively. Accumulated depreciation of assets under capital lease totaled $30.1 million at September 30, 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 $21.2 million and $23.0 million for the three months ended September 30, 2017 and 2016 , respectively. Depreciation and amortization expense totaled $66.4 million and $69.3 million for the nine months ended September 30, 2017 and 2016 , respectively.

Included in property and equipment is approximately $13.8 million and $14.3 million of assets in construction as of September 30, 2017 and December 31, 2016 , respectively, the majority of which relates to internal-use software.


15

SHUTTERFLY, INC.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

Accrued Liabilities
 
September 30, 2017
 
December 31, 2016
 
(in thousands)
Accrued production costs
$
24,607

 
$
38,755

Accrued compensation
17,225

 
17,066

Capital lease obligations, current portion
16,724

 
16,092

Accrued marketing expenses
6,319

 
23,839

Accrued consulting
5,286

 
8,643

Accrued income and sales tax
3,967

 
19,846

Accrued other
16,468

 
14,628

 
$
90,596

 
$
138,869

 
Other Liabilities
 
September 30, 2017
 
December 31, 2016
 
(in thousands)
Financing obligations
$
54,130

 
$
55,355

Capital lease obligations, non-current portion
51,639

 
50,213

Deferred revenue, non-current portion
6,039

 
7,303

Deferred tax liability

 
20,446

Other liabilities
9,714

 
3,718

 
$
121,522

 
$
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 — Debt
Syndicated Credit Facilities
2017 Facility

On August 17, 2017 (“Closing Date”), the Company entered into a credit agreement (“Credit Agreement”) with certain lenders and Morgan Stanley Senior Funding, Inc., as administrative agent and collateral agent. The Credit Agreement provides for (a) a secured revolving loan facility in an aggregate principal amount of up to $200.0 million (“Revolving Loan Facility”) and (b) a secured delayed draw term loan facility (“Term Loan”) in an aggregate principal amount of up to $300.0 million . The Credit Agreement permits the Company to add one or more incremental term loan facilities and/or increase the commitments for revolving loans subject to certain conditions. As of September 30, 2017 , the Company had not drawn on the Term Loan or the Revolving Loan Facility.

On October 18, 2017, the Company fully drew the $300.0 million Term Loan under the Credit Agreement. The full amount of the $200.0 million Revolving Loan Facility remains undrawn as of October 18, 2017. The proceeds of the Term Loan will be used (1) to settle the Company's existing 0.25% Convertible Senior Notes due May 15, 2018 and (2) for working capital and general corporate purposes.

The initial term loans under the Credit Agreement bear interest, at the election of the Company, at either (a) the base rate (the “Base Rate”), which is defined as a fluctuating rate per annum equal to the greatest of (1) the prime rate then in effect, (2) the federal funds rate then in effect, plus 0.50% , and (3) an adjusted LIBOR rate determined on the basis of a one-month interest period, plus 1.0% or (b) an adjusted LIBOR Rate, subject to a floor of 0.0% (the “LIBOR Rate”), in each case, plus an applicable margin of 1.50% per annum in the case of Base Rate loans and 2.50% per annum in the case of LIBOR Rate loans. Upon funding of the Term Loan on October 18, 2017, the Company elected to bear interest rate of one-month LIBOR Rate, subject to a floor of 0.0% , plus an applicable margin of 2.50% per annum.

16

SHUTTERFLY, INC.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS


The revolving loans under the Credit Agreement bear interest, at the election of the Company, at either (a) the Base Rate or (b) the LIBOR Rate, in each case, plus an applicable margin of (1) initially, 0.75% per annum in the case of Base Rate loans and 1.75% per annum in the case of LIBOR Rate loans or (2) following the Company’s delivery of financial statements for the first full fiscal quarter following the Closing Date, 0.50% to 0.75% per annum in the case of Base Rate loans and 1.50% to 1.75% per annum in the case of LIBOR Rate loans, in each case based on the Company’s consolidated secured net leverage ratio, measured as of the end of the most recently ended fiscal quarter. In connection with the Credit Agreement, the Company is also required to pay commitment fees, closing fees, arrangement fees, ticking fees and administration fees, and other customary fees and costs.
The Term Loan has a maturity date of August 17, 2024. Commencing on the last day of the first full fiscal quarter following the Company's borrowing of the Term Loan, the Term loan will amortize in equal quarterly installments of 0.25% of the original principal, with the remaining principal balance payable on the maturity date. Amounts drawn on the Revolving Loan Facility, if any, mature on August 17, 2022. Further, the Company has the right to prepay its borrowings under the Credit Agreement in whole or in part at any time without a premium or penalty, subject to certain limitations and a 1.0% repricing premium applicable during the first six months for the Term Loan. The Credit Agreement also contains certain customary mandatory prepayments under certain conditions as set forth in the Credit Agreement.
The Credit Agreement contains customary affirmative and negative covenants, including covenants that limit or restrict the Company’s and its subsidiaries’ ability to, among other things, incur indebtedness, grant liens, undergo certain fundamental changes, dispose of assets, make investments, enter into transactions with affiliates, and make certain restricted payments, in each case subject to limitations and exceptions set forth in the Credit Agreement. The Company is also required to maintain compliance, measured as of the end of each fiscal quarter, with a consolidated secured net leverage ratio and a consolidated interest expense coverage ratio. As of September 30, 2017 , the Company is in compliance with these covenants.
In August 2017, the Company entered into certain interest-rate swap agreements with an effective date of October 18, 2017 that have the economic effect of modifying a portion of the variable interest-rate obligations associated with the secured delayed draw Term Loan so that the interest payable on such portion become fixed (refer to Note 12 - Derivative Financial Instruments for further details regarding the interest-rate swap agreements).
The Company incurred $5.6 million in credit facility origination costs during the three months ended September 30, 2017 related to the Credit Agreement. These costs have been capitalized within prepaid expenses for the current portion and other assets for the non-current portion. Upon funding of the Term Loan, the related issuance costs will be reclassified to be presented as a reduction to the carrying value of the debt in the consolidated balance sheet. Fees attributable to the Revolving Loan Facility are being amortized over five years and fees attributable to the Term Loan are being amortized over seven years, both as a component of interest expense.

Existing Facility
On August 17, 2017, in connection with the Company’s entry into the new Credit Agreement, the Company terminated its existing credit agreement, dated as of November 22, 2011, as amended as of May 10, 2013, and as further amended and restated as of June 10, 2016 (the “Existing Credit Agreement”). Refer to Note 7 in the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2016 for further details regarding the Existing Credit Agreement.

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.

17

SHUTTERFLY, INC.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

The initial conversion rate is 15.5847 shares of common stock per $1,000 principal amount of Notes. The initial conversion price is $64.17 per share of common stock. Throughout the term of the Notes, the conversion rate may be adjusted upon the occurrence of certain events. Holders of the Notes will not receive any cash payment representing accrued and unpaid interest upon conversion of a Note. Accrued but unpaid interest will be deemed to be paid in full upon conversion rather than cancelled, extinguished or forfeited. Holders may convert their Notes only under the following circumstances:

during any calendar quarter commencing after the calendar quarter ending on September 30, 2013 (and only during such calendar quarter), if the last reported sale price of the Company's common stock for at least 20 trading days (whether or not consecutive) during a period of 30 consecutive trading days ending on the last trading day of the immediately preceding calendar quarter is greater than or equal to 130% of the conversion price on each applicable trading day;
during the five-business day period after any ten consecutive trading day period (the “Notes Measurement Period”) in which the "trading price" (as the term is defined in the Indenture) per $1,000 principal amount of notes for each trading day of such Notes Measurement Period was less than 98% of the product of the last reported sale price of the Company's common stock on such trading day and the conversion rate on each such trading day;
upon the occurrence of specified corporate events; or
at any time on or after December 15, 2017 until the close of business on the second scheduled trading immediately preceding the maturity date.
As of September 30, 2017 , the Notes are not yet convertible. During the second quarter of 2017, the Notes were reclassified from long-term liabilities to current as these are now within one year of maturity.
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. The unamortized issuance costs balance attributable to the liability component was $0.9 million as of September 30, 2017 . Additionally, the Company recorded a deferred tax asset of $0.6 million on a portion of the equity component transaction costs which are deductible for tax purposes.
Concurrently with the Note issuance, the Company repurchased 0.6 million shares of common stock for approximately $30.0 million .
The Notes consist of the following (in thousands):
 
September 30, 2017
 
December 31, 2016
Liability component:
 
 
 
Principal
$
300,000

 
$
300,000

Less: debt issuance costs, debt discount, net of amortization
(9,843
)
 
(21,208
)
Net carrying amount
$
290,157

 
$
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):

18

SHUTTERFLY, INC.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

 
Three Months Ended
 
Nine Months Ended
 
September 30,
 
September 30,
 
2017
 
2016
 
2017
 
2016
0.25% coupon
$
187

 
$
188

 
$
562

 
$
562

Amortization of debt issuance costs
351

 
332

 
1,039

 
982

Amortization of debt discount
3,490

 
3,300

 
10,326

 
9,765

 
$
4,028

 
$
3,820

 
$
11,927

 
$
11,309

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

Note 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 September 30, 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.
On April 18, 2017, the Company's Board of Directors approved an increase of $140.0 million in addition to any amounts repurchased as of that date.
The 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 :

19

SHUTTERFLY, INC.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

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)
 
1,665,360

 

$48.04

 

$80,000


(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 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 nine months ended September 30, 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 incurred to produce personalized products for all of the Company's brands. These costs include direct materials (the majority of which consists of paper, ink, and photo book covers), shipping charges, packing supplies, distribution and fulfillment activities, third-party costs for photo-based merchandise, payroll and related expenses for direct labor and customer service, rent for production facilities, and depreciation of production equipment (primarily digital printing presses and binders) and manufacturing facilities. Cost of net revenues also includes amortization of capitalized website and software development costs, primarily related to adding features and functionality to our website and apps to facilitate product purchases and improve the customer shopping experience. These costs include amortization of third-party software and acquired developed technology as well as patent royalties. Cost of net revenues also includes inventory markdowns that are part of restructuring activities. Cost of net revenues for the SBS segment consists of costs which are direct and incremental to the SBS business. These include production costs of SBS products, such as materials, labor and printing costs and costs associated with third-party production of goods. They also include shipping costs and indirect overhead.

Due to the nature of the Company's operations, a majority of its assets are utilized across all segments. In addition, segment assets are not reported to, or used by, the CODM to allocate resources or assess performance of the Company's segments. Accordingly, the Company has not disclosed asset information by segment.
The Company’s segments are determined based on the products and services it provides and how the CODM evaluates the business. The Company has the following reportable segments:
Consumer - Includes sales from the Company's brands and are derived from the sale of a variety of products, such as cards and stationery, professionally-bound photo books, home décor, personalized gifts, high quality prints, and other photo-based merchandise, and 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.


20

SHUTTERFLY, INC.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

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 and nine months ended September 30, 2017 and 2016 were as follows (dollars in thousands):
 
Three Months Ended
 
Nine Months Ended
 
September 30,
 
September 30,
 
2017
 
2016
 
2017
 
2016
Consumer
 
 
 
 
 
 
 
Net revenues
$
135,418

 
$
144,074

 
$
475,153

 
$
476,072

Cost of net revenues
81,439

 
84,825

 
263,345

 
256,438

Restructuring
39

 

 
1,475

 

Gross profit
$
53,940

 
$
59,249

 
$
210,333

 
$
219,634

Gross profit as a percentage of net revenues
40
%
 
41
%
 
44
%
 
46
%
 
 
 
 
 

 
 
Shutterfly Business Solutions (SBS)
 
 
 
 
 
 
 
Net revenues
$
60,025

 
$
43,254

 
$
121,294

 
$
96,926

Cost of net revenues
47,520

 
30,389

 
95,256

 
71,909

Gross profit
$
12,505

 
$
12,865

 
$
26,038

 
$
25,017

Gross profit as a percentage of net revenues
21
%
 
30
%
 
21
%
 
26
%

 
 
 
 

 
 
Corporate
 
 
 
 
 
 
 
Net revenues
$

 
$

 
$

 
$

Cost of net revenues
2,149

 
2,540

 
6,831

 
7,722

Gross profit
$
(2,149
)
 
$
(2,540
)
 
$
(6,831
)
 
$
(7,722
)

 
 
 
 
 
 
 
Consolidated
 
 
 
 
 
 
 
Net revenues
$
195,443

 
$
187,328

 
$
596,447

 
$
572,998

Cost of net revenues
131,108

 
117,754

 
365,432

 
336,069

Restructuring
39

 

 
1,475

 

Gross profit
$
64,296

 
$
69,574

 
$
229,540

 
$
236,929

Gross profit as a percentage of net revenues
33
%
 
37
%
 
38
%
 
41
%

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.


21

SHUTTERFLY, INC.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

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.


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 following actions were taken:

During the second quarter of 2017, the Company reinvested in Tiny Prints as its premium cards & stationery brand and created a Tiny Prints boutique on a dedicated tab on Shutterfly.com;
During the second quarter, the MyPublisher brand was retired in favor of the industry leading Shutterfly Photo Books category; and
During the third quarter of 2017, the Company launched the new Shutterfly Wedding Shop and shut down the Wedding Paper Divas legacy website
As of September 30, 2017, the Company has substantially completed all actions under the 2017 Restructuring Plan. The Tiny Prints, MyPublisher and Wedding Paper Divas legacy websites were shut down during the first nine months of fiscal 2017. The Company seeks to retain as many customers and as much revenue as possible while migrating customers from the legacy websites to Shutterfly.com. Further, as part of the plan, the Company announced that it would undertake a strategic review of BorrowLenses for possible sale. The Company completed the strategic review process in the third quarter of 2017 and decided to retain and operate the business. Total restructuring costs associated with the 2017 Restructuring Plan were $17.0 million and impacted our restructuring expense line items within cost of net revenues and operating expenses in our condensed consolidated statement of operations as these were incurred during the nine months ended September 30, 2017.

2015 Restructuring Plan

22

SHUTTERFLY, INC.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS


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 nine months ended  September 30, 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
 
8,233

 
5,851

 
1,475

 
1,226

 
181

 
16,966

Cash payments
 
(87
)
 
(4,189
)
 

 
(786
)
 
(268
)
 
(5,330
)
Non-cash adjustments [2]
 
(6,933
)
 
(814
)
 
(1,475
)
 
(23
)
 

 
(9,245
)
Balance as of September 30, 2017 [1]
 
$
1,213

 
$
848

 
$

 
$
417

 
$
1,515

 
$
3,993

 
 
 
 
 
 
 
 
 
 
 
 
 
[1] The balances as of September 30, 2017 and December 31, 2016 are recorded in accrued liabilities.
[2]  Non-cash adjustments include depreciation and amortization of property and equipment (primarily capitalized software development costs and manufacturing equipment) and intangible assets, inventory markdowns, stock-based compensation, and other non-cash costs incurred as part of the restructuring.


23

SHUTTERFLY, INC.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

Note 12 - Derivative Financial Instruments
In August 2017, the Company entered into certain interest-rate swap agreements (“Swap Agreements”) with an aggregate notional amount of $150.0 million and an effective date of October 18, 2017. The Swap Agreements have the economic effect of modifying a portion of the variable interest-rate obligations associated with the Company’s secured delayed draw Term Loan so that the interest payable on such portion of the Term Loan become fixed at a rate of 4.27% (refer to Note 7 - Debt for further details regarding the term loan facility). The Swap Agreements have a maturity date of August 17, 2023 as compared to August 17, 2024 for the Term Loan. Further, the Term Loan has an interest-rate floor, whereas the Swap Agreements do not include a floor. All other critical terms of the Swap Agreements correspond to the Term Loan, including interest-rate reset dates and underlying market indices. The Company fully drew the Term Loan on October 18, 2017 which is also the effective date of the Swap Agreements. The Company has asserted that it is probable that it will have sufficient outstanding debt throughout the life of the Swap Agreements.
The Company has designated the aforementioned Swap Agreements as qualifying hedging instruments and is accounting for them as cash flow hedges pursuant to ASC 815 (as amended by ASU 2017-12). The Company used the hypothetical derivative method to assess the effectiveness of the Swap Agreements. The fair value of the Swap Agreements was recognized gross as other assets and the corresponding changes in fair value were recorded in accumulated other comprehensive income (loss) in the consolidated balance sheet. Since the derivative instrument is an interest-rate swap and the hedged item is interest expense, amounts recorded in other comprehensive income (loss) will be reclassified to interest expense when the hedged interest payment is accrued. The periodic interest settlements for the Swap Agreements are recorded as interest expense and are included as part of the cash flows from operating activities. Amounts expected to be reclassified from other comprehensive income into interest expense in the coming 12 months are $0.4 million .
The fair value of the Swap Agreements was $1.4 million as of September 30, 2017 and was classified as other assets in the balance sheet. The unrealized gains recognized in other comprehensive income (loss) were $1.4 million and no amounts were reclassified from other comprehensive income (loss) to interest expense during the three and nine months ended September 30, 2017 .
The Company does not use derivative financial instruments for trading purposes.

24

SHUTTERFLY, INC.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS


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 “guidance,” “believe,” “anticipate,” “expect,” “estimate,” “intend,” “seek,” “continue,” “should,” “would,” “could,” “will,” or “may,” or the negative of these terms or other comparable terminology. Forward-looking statements involve risks and uncertainties. Our actual results and the timing of events could differ materially from those anticipated in our forward-looking statements as a result of many factors, including but not limited to, decreased consumer discretionary spending as a result of general economic conditions; our ability to expand our customer base and increase sales to existing customers; our ability to meet production requirements; our ability to retain and hire necessary employees, including seasonal personnel, and appropriately staff our operations; the impact of seasonality on our business; our ability to develop innovative, new products and services on a timely and cost-effective basis; failure to realize the anticipated benefits of our 2017 restructuring activities; consumer acceptance of our products and services; our ability to develop additional adjacent lines of business; successfully acquire businesses and technologies and to successfully integrate and operate these acquired businesses and technologies; unforeseen changes in expense levels; competition and the pricing strategies of our competitors, which could lead to pricing pressure; the anticipated benefits of expanding the portions of our public cloud infrastructure and the other risks set forth below under “Risk Factors” in Part II, Item 1A of this report. Given these risks and uncertainties, readers are cautioned not to place undue reliance on such forward-looking statements. We assume no obligation to update any of the forward-looking statements after the date of this report or to compare these forward-looking statements to actual results.

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

We are the leading 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 industry 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, cards and stationery, custom home décor products and unique photo gifts as well as calendars and prints. 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.


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Table of Contents

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

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

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

We generate the majority of our revenues by marketing and manufacturing a variety of products such as cards and stationery, professionally-bound photo books, personalized gifts and home décor, calendars and high-quality prints. We manufacture many of these items in our Fort Mill, South Carolina; Shakopee, Minnesota; and Tempe, Arizona production facilities. By operating our own production facilities, we can produce high-quality products, innovate rapidly, maintain a favorable cost structure and ensure timely shipment to customers, even during peak periods of demand. We also operate a network of partners and can seamlessly manage demand across it. 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 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. Further, Tiny Prints generates approximately 70% of its revenue in the fourth quarter. Our operations and financial performance depend on general economic conditions in the United States, consumer sentiment, and the levels of consumer discretionary spending. We closely monitor these economic measures as their trends are indicators of the health of the overall economy and are some of the key external factors that impact our business.

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

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

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.

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

During the second quarter of 2017, we reinvested in Tiny Prints as our premium cards & stationery brand and created a Tiny Prints boutique on a dedicated tab on Shutterfly.com;
During the second quarter, the MyPublisher brand was retired in favor of the industry leading Shutterfly Photo Books category; and
During the third quarter of 2017, we launched the new Shutterfly Wedding Shop and shut down the Wedding Paper Divas legacy website. The Shutterfly Wedding Shop is a broad offering of personalized wedding products, including invitations, stationery, gifts, keepsakes and albums

As of September 30, 2017, we have substantially completed all actions under the 2017 Restructuring Plan. The Tiny Prints, MyPublisher and Wedding Paper Divas legacy websites were shut down during the first nine months of fiscal 2017. We seek to retain as many customers and as much revenue as possible while migrating customers from the legacy websites to Shutterfly.com. Further, as part of the plan, we announced that we would undertake a strategic review of BorrowLenses for possible sale. We completed the strategic review process in the third quarter of 2017 and decided to retain and operate the business. Total restructuring

26

Table of Contents

costs associated with the 2017 Restructuring Plan were $17.0 million and impacted our restructuring expense line items within cost of net revenues and operating expenses in our condensed consolidated statement of operations as these were incurred during the nine months ended September 30, 2017.

Also, during the second quarter of 2017, the Company took advantage of an opportunity to complete the upgrade of our color printer fleet. The benefits of the upgrade are improved quality, increased throughput and automation, and lower consumable costs. The Company expects the new equipment to result in approximately $15.0 million in expense savings over the next five years. There are three pieces of this transaction as follows:
Purchase of leased equipment from an existing vendor for $21.6 million ;
Sale of the purchased leased equipment to HP, Inc. ("HP") for $20.5 million ; and
Lease of new equipment from HP

In the purchase of the existing leased equipment, the difference between the payment of $21.6 million and the fair value of the asset, resulted in an $8.1 million capital lease termination charge (separate line item in the condensed consolidated statement of operations). The purchased equipment assets were recorded on the balance sheet at fair value of $12.9 million . The subsequent sale of the equipment to HP for $20.5 million resulted in the removal of the equipment assets and a capital lease incentive of $7.9 million to be amortized over the new lease term. Lastly, the Company leased new equipment from HP which upgrades most of our remaining color fleet to HP's high-end printers.

During the third quarter of 2017, we signed a multiyear deal with Amazon Web Services, Inc. to migrate to the cloud. This deal will position us to benefit from cost-effective scaling versus remaining in our own data center, enabling us to deliver innovative features and improve customer experience. Beyond the cost savings, we'll see benefits from higher developer productivity and speed of innovation.

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 our brands and are derived from the sale of a variety of products such as, professionally-bound photo books, cards and stationery, custom home décor products and unique photo gifts, calendars and prints, and the related shipping revenues as well as rental revenue from our BorrowLenses brand. Revenue from advertising displayed on our websites is also included in Consumer revenues.
 
SBS.      Our SBS revenues are primarily from 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 represent the number of transacting customers in a given period. An active customer is defined as one that has transacted in the last trailing twelve months. We seek to expand our customer base by empowering our existing customers with sharing and collaboration services, and by conducting integrated marketing and advertising programs. We also acquire new customers through customer list acquisitions. Total customers generally 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

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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 generally have increased on an annual basis for each year since inception.
 
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 incurred to produce personalized products for all of our brands. These costs include direct materials (the majority of which consists of paper, ink, and photo book covers), shipping charges, packing supplies, distribution and fulfillment activities, third-party costs for photo-based merchandise, payroll and related expenses for direct labor and customer service, rent for production facilities, and depreciation of production equipment (primarily digital printing presses and binders) and manufacturing facilities. Cost of net revenues also includes amortization of capitalized website and software development costs, primarily related to adding features and functionality to our website and apps to facilitate product purchases and improve the customer shopping experience. These costs include amortization of third-party software and acquired developed technology as well as patent royalties. Cost of net revenues also includes inventory markdowns that are part of restructuring activities.

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

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

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

Technology and development expense consists primarily of salaries and benefits for employees and professional fees for contractors engaged in the maintenance and support of our website, developing features and functionality for our free photo storage service, and developing and maintaining internal infrastructure such as our ERP, internal reporting tools and network security and data encryption systems. These expenses include depreciation of computer and network hardware used to run our websites, store user photos and related data, and support our infrastructure, as well as amortization of software used to operate such hardware. Technology and development expense also includes co-location, power and bandwidth costs.

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

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


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Table of Contents

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 syndicated credit facilities, and costs associated with our capital leases and build-to-suit lease financing obligations.

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

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

Critical Accounting Policies and Estimates

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

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


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Table of Contents

Results of Operations

The following table presents the components of our statement of operations as a percentage of net revenues:
 
Three Months Ended
 
Nine Months Ended
 
September 30,
 
September 30,
 
2017
 
2016
 
2017
 
2016
Net revenues
100
 %
 
100
 %
 
100
 %
 
100
 %
Cost of net revenues
67
 %
 
63
 %
 
62
 %
 
59
 %
Restructuring
 %
 
 %
 
 %
 
 %
Gross profit
33
 %
 
37
 %
 
38
 %
 
41
 %
Operating expenses:
 
 
 
 
 
 
 
Technology and development
20
 %
 
23
 %
 
21
 %
 
21
 %
Sales and marketing
17
 %
 
22
 %
 
20
 %
 
24
 %
General and administrative
12
 %
 
14
 %
 
13
 %
 
15
 %
Capital lease termination
 %
 
 %
 
1
 %
 
 %
Restructuring
2
 %
 
 %
 
3
 %
 
 %
Total operating expenses
51
 %
 
59
 %
 
58
 %
 
60
 %
Loss from operations
(18
)%
 
(22
)%
 
(20
)%
 
(19
)%
Interest expense
(4
)%
 
(3
)%
 
(3
)%
 
(2
)%
Interest and other income, net
 %
 
 %
 
 %
 
 %
Loss before income taxes
(22
)%
 
(25
)%
 
(23
)%
 
(21
)%
Benefit from income taxes
9
 %
 
10
 %
 
9
 %
 
8
 %
Net loss
(13
)%
 
(15
)%
 
(14
)%
 
(13
)%


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Table of Contents

Comparison of the Three Month Periods Ended September 30, 2017 and 2016
 
 
Three Months Ended September 30,
 
 
2017
 
2016
 
$ Change
 
% Change
 
 
(in thousands)
Consolidated
 
 
 
 
 
 
 
 
Net revenues
 
$
195,443

 
$
187,328

 
$
8,115

 
4
 %
Cost of net revenues
 
131,108

 
117,754

 
13,354

 
11
 %
Restructuring
 
39

 

 
39

 
100
 %
Gross profit
 
$
64,296

 
$
69,574

 
$
(5,278
)
 
(8
)%
Gross profit as a percentage of net revenues
 
33
%
 
37
%
 
 
 
 

Net revenues increased $8.1 million , or 4% , for the three months ended September 30, 2017 as compared to the same period in 2016 . Cost of net revenues increased $13.4 million , or 11% , for the three months ended September 30, 2017 as compared to the same period in 2016 . As a percentage of net revenues, cost of net revenues increased to 67% in the three months ended September 30, 2017 from 63% in 2016 . Gross margin decreased to 33% in the three months ended September 30, 2017 from 37% in the same period in 2016 primarily due to greater SBS segment mix and lower gross margins in the SBS segment.

Consumer Segment

 
 
Three Months Ended September 30,
 
 
2017
 
2016
 
$ Change
 
% Change
 
 
(in thousands)
Consumer
 
 
 
 
 
 
 
 
Net revenues
 
$
135,418

 
$
144,074

 
$
(8,656
)
 
(6
)%
Cost of net revenues
 
81,439

 
84,825

 
(3,386
)
 
(4
)%
Restructuring
 
39

 

 
39

 
100
 %
Gross profit
 
$
53,940

 
$
59,249

 
$
(5,309
)
 
(9
)%
Gross profit as a percentage of net revenues
 
40
%
 
41
%
 
 
 
 
 
 
Three Months Ended September 30,
 
 
2017
 
2016
 
Change
 
% Change
 
 
(in thousands, except AOV amounts)
Key Consumer Metrics
 
 
Total Customers
 
2,969

 
3,151

 
(182
)
 
(6
)%
Total Number of Orders
 
4,861

 
5,395

 
(534
)
 
(10
)%
Average order value (AOV)
 
$
27.86

 
$
26.71

 
$
1.15

 
4
 %

Consumer net revenues decreased $8.7 million , or 6% , in the three months ended September 30, 2017 compared to the same period in 2016 . The decrease in Consumer net revenues was due to anticipated revenue declines in the non-Shutterfly brands due to the platform consolidation and the brand shutdowns over the course of the nine months ended September 30, 2017. Total customers decreased 6% and total number of orders decreased 10% , while AOV increased 4% in the three months ended September 30, 2017 compared to the same period in 2016 . The decrease in total customers and total number of orders was primarily due to the consumer platform consolidation. AOV increased due to product mix and a lower level of free products in our promotional mix.

Consumer cost of net revenues decreased $3.4 million , or 4% , for the three months ended September 30, 2017 as compared to the same period in 2016 . The decrease in cost of net revenues is primarily due to changes in product mix and lower overall consumer volume due to the platform consolidation and improved partner outsourcing costs.

Consumer gross margin decreased to 40% in the three months ended September 30, 2017 from 41% in the same period in 2016 . Restructuring charges related to the markdowns of inventories which were determined to be obsolete had an immaterial impact on gross margin in the three months ended September 30, 2017.


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Table of Contents

SBS Segment

 
 
Three Months Ended September 30,
 
 
2017
 
2016
 
$ Change
 
% Change
 
 
(in thousands)
Shutterfly Business Solutions (SBS)
 
 
 
 
 
 
 
 
Net revenues
 
$
60,025

 
$
43,254

 
$
16,771

 
39
 %
Cost of net revenues
 
47,520

 
30,389

 
17,131

 
56
 %
Gross profit
 
$
12,505

 
$
12,865

 
$
(360
)
 
(3
)%
Gross profit as a percentage of net revenues
 
21
%
 
30
%
 
 
 
 

SBS net revenues increased $16.8 million , or 39% , in the three months ended September 30, 2017 compared to the same period in 2016 . The increase in SBS net revenues came both from expansion of projects and higher volumes with existing clients, which included a new multi-year deal with an existing technology client.

SBS cost of net revenues increased $17.1 million , or 56% , for the three months ended September 30, 2017 as compared to the same period in 2016 . SBS gross margin decreased to 21% in the three months ended September 30, 2017 from 30% in the same period in 2016 primarily due to lower gross margin on a major new deal we signed with an existing technology client which has low margins during the initial ramp up period. We expect gross margin in connection with this strategic relationship to be lower during the initial ramp period yet to improve over the life of the deal.

Corporate Segment

 
 
Three Months Ended September 30,