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EX-32.01 - EXHIBIT 32.01 - SHUTTERFLY INCex32_01.htm
EX-31.02 - EXHIBIT 31.02 - SHUTTERFLY INCex31_02.htm
EX-32.02 - EXHIBIT 32.02 - SHUTTERFLY INCex32_02.htm
EX-31.01 - EXHIBIT 31.01 - SHUTTERFLY INCex31_01.htm


UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, DC 20549

Form 10-Q

(Mark One)
x
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended September 30, 2011
or
o
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from            to

Commission file number 001-33031

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

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

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

Registrant’s Telephone Number, Including Area Code
(650) 610-5200
 
Indicate by check mark whether the Registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes   x       No  o

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

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

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

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

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

Class
 
Outstanding at October 27, 2011
Common stock, $0.0001 par value per share
 
34,671,022
 


 
 

 
 

 
Page
Number
Part I - Financial Information
 
Item 1. Financial Statements
 
3
4
5
6
15
25
25
Part II - Other Information
 
26
Item 1A.  Risk Factors
26
41
41
   41
Item 6.  Exhibits
42
43
44
EXHIBIT 31.01
 
EXHIBIT 31.02
 
EXHIBIT 32.01
 
EXHIBIT 32.02
 
EXHIBIT 101
 
 
 
PART IFINANCIAL INFORMATION


Item 1. Condensed Consolidated Financial Statements

SHUTTERFLY, INC.
(In thousands, except par value amounts)
(Unaudited)
 
 
 
September 30,
2011
 
 
December 31,
2010
 
ASSETS
 
 
 
 
 
 
Current assets:
 
 
 
 
 
 
Cash and cash equivalents
 
$
68,710
 
 
$
252,244
 
Accounts receivable, net
 
 
8,375
 
 
 
4,845
 
Inventories
 
 
3,027
 
 
 
3,580
 
Deferred tax asset, current portion
 
 
327
 
 
 
3,582
 
Prepaid expenses and other current assets
 
 
57,539
 
 
 
6,934
 
Total current assets
 
 
137,978
 
 
 
271,185
 
Property and equipment, net
 
 
53,103
 
 
 
39,726
 
Intangible assets, net
 
 
98,611
 
 
 
5,672
 
Goodwill
 
 
342,431
 
 
 
11,163
 
Deferred tax asset, net of current portion
 
 
-
 
 
 
11,314
 
Other assets
 
 
5,055
 
 
 
4,770
 
Total assets
 
$
637,178
 
 
$
343,830
 
LIABILITIES AND STOCKHOLDERS’ EQUITY
 
 
 
 
 
 
 
 
Current liabilities:
 
 
 
 
 
 
 
 
Accounts payable
 
$
10,652
 
 
$
22,341
 
Accrued liabilities
 
 
23,864
 
 
 
38,831
 
Deferred revenue
 
 
11,459
 
 
 
9,731
 
Total current liabilities
 
 
45,975
 
 
 
70,903
 
Deferred tax liability
 
 
15,830
 
 
 
-
 
Other liabilities
 
 
5,383
 
 
 
3,320
 
Total liabilities
 
 
67,188
 
 
 
74,223
 
Commitments and contingencies (Note 6)
 
 
 
 
 
 
 
 
Stockholders’ equity
 
 
 
 
 
 
 
 
Common stock, $0.0001 par value; 100,000 shares authorized; 34,666 and 27,957 shares issued
and outstanding on September 30, 2011 and December 31, 2010, respectively
 
 
3
 
 
 
3
 
Additional paid-in capital
 
 
585,471
 
 
 
263,726
 
Accumulated earnings (deficit)
 
 
(15,484
)
 
 
5,878
 
Total stockholders' equity
 
 
569,990
 
 
 
269,607
 
Total liabilities and stockholders' equity
 
$
637,178
 
 
$
343,830
 
 
The accompanying notes are an integral part of these condensed consolidated financial statements.
 
 
SHUTTERFLY, INC.
(In thousands, except per share amounts)
(Unaudited)

 
 
Three Months Ended
September 30,
 
 
Nine Months Ended
September 30,
 
 
 
2011
 
 
2010
 
 
2011
 
 
2010
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Net revenues
 
$
76,523
 
 
$
48,958
 
 
$
209,516
 
 
$
141,507
 
Cost of net revenues
 
 
41,647
 
 
 
24,906
 
 
 
111,074
 
 
 
70,663
 
Gross profit
 
 
34,876
 
 
 
24,052
 
 
 
98,442
 
 
 
70,844
 
Operating expenses:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Technology and development
 
 
18,106
 
 
 
11,602
 
 
 
48,190
 
 
 
36,248
 
Sales and marketing
 
 
25,252
 
 
 
11,500
 
 
 
64,447
 
 
 
32,968
 
General and administrative
 
 
14,210
 
 
 
8,927
 
 
 
43,023
 
 
 
27,348
 
Total operating expenses
 
 
57,568
 
 
 
32,029
 
 
 
155,660
 
 
 
96,564
 
Loss from operations
 
 
(22,692
)
 
 
(7,977
)
 
 
(57,218
)
 
 
(25,720
)
Interest expense
 
 
-
 
 
 
-
 
 
 
-
 
 
 
(42
)
Interest and other income, net
 
 
5
 
 
 
26
 
 
 
25
 
 
 
462
 
Loss before income taxes
 
 
(22,687
)
 
 
(7,951
)
 
 
(57,193
)
 
 
(25,300
)
Benefit from income taxes
 
 
12,734
 
 
 
3,181
 
 
 
35,830
 
 
 
9,914
 
Net loss
 
$
(9,953
)
 
$
(4,770
)
 
$
(21,363
)
 
$
(15,386
)
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Net loss per share - basic and diluted
 
$
(0.29
)
 
$
(0.17
)
 
$
(0.66
)
 
$
(0.57
)
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Weighted-average shares outstanding - basic and diluted
 
 
34,576
 
 
 
27,292
 
 
 
32,136
 
 
 
26,827
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Stock-based compensation is allocated as follows:
 
 
 
 
 
 
 
 
 
 
 
 
 
Cost of net revenues
 
$
584
 
 
$
120
 
 
$
1,513
 
 
$
380
 
Technology and development
 
 
2,353
 
 
 
759
 
 
 
6,019
 
 
 
2,316
 
Sales and marketing
 
 
3,259
 
 
 
870
 
 
 
8,776
 
 
 
2,938
 
General and administrative
 
 
3,626
 
 
 
2,117
 
 
 
10,848
 
 
 
6,665
 
 
The accompanying notes are an integral part of these condensed consolidated financial statements.
 
 
SHUTTERFLY, INC.
(In thousands)
(Unaudited)

 
 
Nine Months Ended
September 30,
 
 
 
2011
 
 
2010
 
Cash flows from operating activities:
 
 
 
 
 
 
Net loss
 
$
(21,363
)
 
$
(15,386
)
Adjustments to reconcile net loss to net cash used in operating activities:
 
 
 
 
 
 
 
 
Depreciation and amortization
 
 
16,359
 
 
 
18,398
 
Amortization of intangible assets
 
 
8,167
 
 
 
1,892
 
Stock-based compensation, net of forfeitures
 
 
27,156
 
 
 
12,299
 
Gain on disposal of property and equipment
 
 
(155
)
 
 
(243
)
Deferred income taxes
 
 
(1,851
)
 
 
(3,285
)
Tax benefit from stock-based compensation
 
 
12,363
 
 
 
4,302
 
Excess tax benefits from stock-based compensation
 
 
(12,386
)
 
 
(4,687
)
Changes in operating assets and liabilities:
 
 
 
 
 
 
 
 
Accounts receivable, net
 
 
(2,583
)
 
 
3,027
 
Inventories
 
 
1,464
 
 
 
(459
)
Prepaid expenses and other current assets
 
 
(48,978
)
 
 
(14,362
)
Other assets
 
 
(809
)
 
 
1,977
 
Accounts payable
 
 
(15,993
)
 
 
(4,935
)
Accrued and other liabilities
 
 
(22,204
)
 
 
(16,997
)
Deferred revenue
 
 
1,222
 
 
 
567
 
Net cash used in operating activities
 
 
(59,591
)
 
 
(17,892
)
Cash flows from investing activities:
 
 
 
 
 
 
 
 
Acquisition of business and intangibles, net of cash acquired
 
 
(134,036
)
 
 
(150
)
Purchases of property and equipment
 
 
(16,319
)
 
 
(11,532
)
Capitalization of software and website development costs
 
 
(7,877
)
 
 
(4,608
)
Proceeds from sale of equipment
 
 
326
 
 
 
216
 
Proceeds from the sale of auction rate securities
 
 
-
 
 
 
47,925
 
Net cash provided by (used in) investing activities
 
 
(157,906
)
 
 
31,851
 
Cash flows from financing activities:
 
 
 
 
 
 
 
 
Principal payments of capital lease obligations
 
 
(6
)
 
 
(7
)
Proceeds from issuance of common stock upon exercise of stock options
 
 
21,583
 
 
 
9,061
 
Excess tax benefits from stock-based compensation
 
 
12,386
 
 
 
4,687
 
Net cash provided by financing activities
 
 
33,963
 
 
 
13,741
 
Net increase (decrease) in cash and cash equivalents
 
 
(183,534
)
 
 
27,700
 
Cash and cash equivalents, beginning of period
 
 
252,244
 
 
 
132,812
 
Cash and cash equivalents, end of period
 
$
68,710
 
 
$
160,512
 
 
 
 
 
 
 
 
 
 
Supplemental schedule of non-cash investing activities
 
 
 
 
 
 
 
 
Net change in accrued purchases of property and equipment
 
$
2,248
 
 
$
741
 
Amount due from adjustment of net working capital from acquired business
 
 
505
 
 
 
-
 
 
The accompanying notes are an integral part of these condensed consolidated financial statements.
 
 
SHUTTERFLY, INC.

Note 1 — The Company and Summary of Significant Accounting Policies

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

Basis of Presentation

The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America for interim financial information and, accordingly, do not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements. The accompanying unaudited condensed consolidated financial statements include the accounts of Shutterfly, Inc. and its wholly owned subsidiaries. In the opinion of management, all adjustments, consisting primarily of normal recurring accruals, considered necessary for a fair statement of the Company’s results of operations for the interim periods reported and of its financial position as of the date of the interim balance sheets have been included. Operating results for the three and nine months ended September 30, 2011 are not necessarily indicative of the results that may be expected for the year ending December 31, 2011, or for any other period.

The December 31, 2010 condensed consolidated balance sheet data was derived from audited financial statements, but does not include all disclosures required by accounting principles generally accepted in the United States of America. These unaudited interim condensed consolidated financial statements should be read in conjunction with the consolidated financial statements and related notes for the year ended December 31, 2010 included in the Company’s Annual Report on Form 10-K.

Fair Value

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

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

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

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

Income Taxes

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

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

 
SHUTTERFLY, INC.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

The Company’s policy is to recognize interest and /or penalties related to all tax positions in income tax expense.  To the extent that accrued interest and penalties do not ultimately become payable, amounts accrued will be reduced and reflected as a reduction of the overall income tax provision in the period that such determination is made.  No interest and penalties were accrued as of December 31, 2010 and September 30, 2011.

The Company is subject to taxation in the United States, California and fourteen other jurisdictions in the United States.
 
Recent Accounting Pronouncements

 No new accounting standards have been adopted since the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2010 was filed.

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

Note 2 — Stock-Based Compensation

Stock Option Activity

A summary of the Company’s stock option activity for the three and nine months ended September 30, 2011 is as follows (share numbers and aggregate intrinsic values in thousands):
 
 
 
Number of Options Outstanding
 
 
Weighted Average Exercise Price
 
 
Weighted Average Contractual Term (Years)
 
 
Aggregate Intrinsic Value
 
Balances, December 31, 2010
 
 
3,357
 
 
$
 15.33
 
 
 
 
 
 
 
Granted
 
 
 75
 
 
 
44.70
 
 
 
 
 
 
 
Exercised
 
 
 (813
)
 
 
9.15
 
 
 
 
 
 
 
Forfeited, cancelled or expired
 
 
(12
)
 
 
19.17
 
 
 
 
 
 
 
Balances, March 31, 2011
 
 
 2,607
 
 
$
 18.09
 
 
 
6.4
 
 
$
 89,346
 
Granted
 
 
16
 
 
 
52.72
 
 
 
 
 
 
 
 
 
Exercised
 
 
(911
)
 
 
11.83
 
 
 
 
 
 
 
 
 
Forfeited, cancelled or expired
 
 
(41
)
 
 
18.72
 
 
 
 
 
 
 
 
 
Increase due to acquisition
 
 
1,345
 
 
 
5.35
 
 
 
 
 
 
 
 
 
Balances, June 30, 2011
 
 
3,016
 
 
$
14.48
 
 
 
6.9
 
 
$
129,502
 
Granted
   
68
     
51.88
                 
Exercised
   
(217
)
   
15.43
                 
Forfeited, cancelled or expired
   
(51
)
   
12.06
                 
Balances, September 30, 2011
   
2,816
   
$
15.36
     
6.7
   
$
73,909
 
Options vested and expected to vest at September 30, 2011
 
 
2,660
 
 
$
15.10
 
 
 
6.6
 
 
$
70,374
 
Options vested at September 30, 2011
 
 
2,124
 
 
$
13.39
 
 
 
6.1
 
 
$
59,031
 

During the three months ended September 30, 2011, the Company granted options to purchase an aggregate of 68,000 shares of common stock with an estimated weighted-average grant-date fair value of $22.94 per share. The total intrinsic value of options exercised during the three months ended September 30, 2011, was $9,105,000.  Net cash proceeds from the exercise of stock options were $3,356,000 for the three months ended September 30, 2011.
 

SHUTTERFLY, INC.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

Valuation of Stock Options

The Company estimated the fair value of each option award on the date of grant using the Black-Scholes option-pricing model and the assumptions noted in the following table.  In the three and nine months ended September 30, 2011, the Company calculated volatility using an average of its historical and implied volatilities as it had sufficient public trading history to cover the entire expected term.  In all prior periods, expected volatility also included historical and implied volatility of a peer group of publicly traded entities. The expected term of options gave consideration to historical exercises, post-vesting cancellations and the options’ contractual term. The risk-free rate for the expected term of the option is based on the U.S. Treasury Constant Maturity at the time of grant. The assumptions used to value options granted during the three and nine months ended September 30, 2011 and 2010 were as follows:
 
 
 
Three Months Ended
September 30,
 
 
Nine Months Ended
September 30,
 
 
 
2011
 
 
2010
 
 
2011
 
 
2010
 
Dividend yield
 
 
 
 
 
 
 
 
 
 
 
 
Annual risk free rate of return
 
 
1.1
%
 
 
1.5
%
 
 
1.7
%
 
 
2.1
%
Expected volatility
 
 
54.7
%
 
 
52.5
%
 
 
51.5
%
 
 
51.1
%
Expected term (years)
 
 
4.3
 
 
 
4.5
 
 
 
4.4
 
 
 
4.5
 

Employee stock-based compensation expense recognized in the three and nine months ended September 30, 2011 and 2010, was calculated based on awards ultimately expected to vest and has been reduced for estimated forfeitures. Accounting standards require forfeitures to be estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates.

Restricted Stock Units

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

Restricted Stock Unit Activity

A summary of the Company’s restricted stock unit activity for the three and nine months ended September 30, 2011, is as follows (share numbers in thousands):
 
 
 
Number of Units Outstanding
 
 
Weighted Average Grant Date Fair Value
 
Awarded and unvested, December 31, 2010
 
 
2,019
 
 
$
15.76
 
Granted
 
 
723
 
 
 
45.13
 
Vested
 
 
(547
)
 
 
13.62
 
Forfeited
 
 
(41
)
 
 
23.16
 
Awarded and unvested, March 31, 2011
 
 
2,154
 
 
$
26.02
 
Granted
 
 
98
 
 
 
53.39
 
Vested
 
 
(169
)
 
 
15.50
 
Forfeited
 
 
(106
)
 
 
25.22
 
Increase due to acquisition
 
 
64
 
 
 
55.36
 
Awarded and unvested, June 30, 2011
 
 
2,041
 
 
$
29.17
 
Granted
   
116
     
52.06
 
Vested
   
(35
)
   
19.37
 
Forfeited
   
(41
)
   
31.63
 
Awarded and unvested, September 30, 2011
   
2,081
   
$
30.53
 
Restricted stock units expected to vest, September 30, 2011
 
 
1,617
 
 
 
 
 
 
 
SHUTTERFLY, INC.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

Included in the RSU grants for the nine months ended September 30, 2011, are 155,000 RSUs that have both performance and service vesting criteria (“PBRSU”).  The performance criteria are tied to the Company’s 2011 financial performance and the service criteria are consistent with vesting described in the Company's 2006 Equity Incentive Plan.  Compensation cost associated with these PBRSUs is recognized on an accelerated attribution model and ultimately based on whether or not satisfaction of the performance criteria is probable.  If in the future, situations indicate that the performance criteria are not probable, then no further compensation cost will be recorded and any previous costs will be reversed.

At September 30, 2011, the Company had $63,042,000 of total unrecognized compensation expense, net of estimated forfeitures, related to stock options and RSUs that will be recognized over a weighted-average period of approximately two years.

Note 3 — Net Loss Per Share

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

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

A summary of the net loss per share for the three and nine months ended September 30, 2011 and 2010 is as follows (in thousands, except per share amounts):
 
 
 
Three Months Ended
September 30,
   
Nine Months Ended
September 30,
 
 
 
2011
   
2010
   
2011
   
2010
 
Net loss per share:
 
 
   
 
   
 
   
 
 
Numerator
 
 
   
 
   
 
   
 
 
Net loss
  $ (9,953 )   $ (4,770 )   $ (21,363 )   $ (15,386 )
Denominator for basic and diluted net loss per share
                               
Weighted-average common shares outstanding
    34,576       27,292       32,136       26,827  
Net loss per share — basic and diluted
  $ (0.29 )   $ (0.17 )   $ (0.66 )   $ (0.57 )

 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
September 30,
 
 
Nine Months Ended
September 30,
 
 
 
2011
 
 
2010
 
 
2011
 
 
2010
 
Stock options and restricted stock units
 
 
4,939
 
 
 
5,724
 
 
 
5,620
 
 
 
6,049
 
 
 
SHUTTERFLY, INC.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
 
Note 4 — Fair Value Measurement
 
The following table represents the Company’s fair value hierarchy for its financial assets as of September 30, 2011 and December 31, 2010 (in thousands):

 
 
September 30, 2011
 
 
 
Fair Value
 
 
Level 1
 
Cash equivalents:
 
 
 
 
 
 
Money market funds
 
$
68,710
 
 
$
68,710
 
Total financial assets
 
$
68,710
 
 
$
68,710
 

 
 
December 31, 2010
 
 
 
Fair Value
 
 
Level 1
 
Cash equivalents:
 
 
 
 
 
 
Money market funds
 
$
211,385
 
 
$
211,385
 
Total financial assets
 
$
211,385
 
 
$
211,385
 

As of September 30, 2011 and December 31, 2010, the Company held Level 1 financial assets which were all invested in money market funds, primarily in U.S. Treasury and U.S. agency securities.

Note 5 — Balance Sheet Components

Prepaid Expenses and Other Current Assets
 
 
 
September 30,
2011
 
 
December 31,
2010
 
 
 
(in thousands)
 
Intra-period tax asset
 
$
46,343
 
 
$
-
 
Prepaid service contracts – current portion
 
 
3,937
 
 
 
3,189
 
Prepaid income taxes
 
 
1,178
 
 
 
611
 
Other prepaid expenses and current assets
 
 
6,081
 
 
 
3,134
 
 
 
$
57,539
 
 
$
6,934
 
 
Intra-period tax asset represents the cumulative income tax benefit recorded as of the balance sheet date, which will offset against taxes payable, or become a component of deferred taxes on a full year basis.
 
Property and Equipment

 
 
September 30,
2011
 
 
December 31,
2010
 
 
 
(in thousands)
 
Computer and other equipment
 
$
100,959
 
 
$
87,531
 
Software
 
 
11,329
 
 
 
9,124
 
Leasehold improvements
 
 
9,274
 
 
 
7,133
 
Furniture and fixtures
 
 
3,718
 
 
 
3,006
 
Capitalized software and website development costs
 
 
33,566
 
 
 
25,173
 
 
 
 
158,846
 
 
 
131,967
 
Less: accumulated depreciation and amortization
 
 
(105,743
)
 
 
(92,241
)
Net property and equipment
 
$
53,103
 
 
$
39,726
 

Depreciation and amortization expense totaled $5,572,000 and $5,718,000 for the three months ended September 30, 2011 and 2010, respectively.  Depreciation and amortization expense totaled $16,359,000 and $18,398,000 for the nine months ended September 30, 2011 and 2010, respectively.
 
 
SHUTTERFLY, INC.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

Accrued Liabilities
 
 
 
September 30,
  2011
 
 
December 31,
2010
 
 
 
(in thousands)
 
Accrued compensation
 
$
5,642
 
 
$
5,701
 
Accrued marketing expenses
 
 
4,838
 
 
 
11,766
 
Accrued production costs
 
 
3,726
 
 
 
8,551
 
Accrued income and sales taxes
 
 
3,034
 
 
 
7,342
 
Accrued consulting
 
 
1,215
 
 
 
1,750
 
Accrued other
 
 
5,409
 
 
 
3,721
 
 
 
$
23,864
 
 
$
38,831
 
 
Note 6 — Commitments and Contingencies

Indemnifications

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

Contingencies

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

Legal Matters

On October 1, 2010, Express Card Systems, LLC filed a complaint for alleged patent infringement against the Company and four other defendants in Express Card Systems, LLC. v. Shutterfly, Inc. et. al., Civ. No. 6:10-cv-514, in the U.S. District Court for the Eastern District of Texas, Tyler Division.  The complaint asserts infringement of U.S. Patent No. 5,751,590, which claims, among other things, a method related to processing images to define social expression cards in a computer database.  The Complaint asserts that the Company directly or indirectly infringes the patents without providing any details concerning the alleged infringement, and it seeks unspecified damages and injunctive relief.  On December 27, 2010, the Company filed an answer and counterclaims against Express Card Systems.  On May 20, 2011, the court for the Eastern District of Texas, Tyler Division, granted Express Card Systems, LLC’s Stipulation of Joint Dismissal without Prejudice of all claims and counterclaims between Express Card and Shutterfly.
 
On December 10, 2010, Eastman Kodak Company filed a complaint for alleged patent infringement against the Company in Eastman Kodak Company v. Shutterfly, Inc., C.A. No. 10-1079-SLR, in the U.S. District Court for the District of Delaware.  The complaint asserts infringement of U.S. Patents Nos. 6,549,306; 6,600,572; 7,202,982; 6,069,712; and 6,512,570, which claim among other things, methods for selecting photographic images using index prints, an image handling system incorporating coded instructions, and processing a roll of exposed photographic film into corresponding visual prints and distributing such prints.  The Complaint asserts that the Company directly or indirectly infringes the patents without providing any details concerning the alleged infringement, and it seeks unspecified damages and injunctive relief.  On February 3, 2011, the Company filed an answer and counterclaims against Eastman Kodak Company.

On January 31, 2011, the Company filed a complaint for patent infringement against Eastman Kodak Company and Kodak Imaging Network, Inc. (“Kodak”) in Shutterfly, Inc. v. Eastman Kodak Company and Kodak Imaging Network, Inc., C.A. No. 11-099-SLR, in the U.S. District Court for the District of Delaware.  The complaint asserts infringement of U.S. Patents Nos.  6,583,799; 7,269,800; 6,587,596; 6,973,222; 7,474,801; 7,016,869; and 7,395,229, which claim among other things, methods for image uploading, image cropping, automatic generation of photo albums, and changing attributes of an image-based product.  The Complaint asserts that Kodak directly or indirectly infringes the patents, and it seeks unspecified damages and injunctive relief.  On March 24, 2011, Kodak filed an answer and counterclaims against the Company.
 
 
SHUTTERFLY, INC.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

On September 10, 2011, Princeton Digital Image Corporation (“Princeton”) filed a complaint for alleged patent infringement against the Company and seven other defendants in Princeton Digital Image Corporation v. Facebook, Inc. et al., Civ. No. 2:2011cv00400, in the U.S. District Court for the Eastern District of Texas, Tyler Division.  The complaint asserts infringement of U.S. Patent No. 4,813,056, which claims, among other things, a method for encoding user’s images.  The Complaint asserts that the Company directly or indirectly infringes the patent without providing any details concerning the alleged infringement, and it seeks unspecified damages and injunctive relief.  On September 12, 2011, Princeton filed a First Amended Complaint adding additional defendants.

On September 15, 2011, Select Retrieval, LLC (“Select Retrieval”) filed identical complaints for alleged patent infringement against Shutterfly and Tiny Prints as well as 32 other defendants in Select Retrieval, LLC. v. American Apparel, LLC et. al., Civ. No. 3:2011cv02158, in the USDC Southern District of California.  The complaint asserts infringement of U.S. Patent No. 6,128,617, which claims, among other things, a method allowing users to perform sequential searches using computer databases and/or the Internet.  The Complaint asserts that the Company directly or indirectly infringes the patent without providing any details concerning the alleged infringement, and it seeks unspecified damages and injunctive relief.

The Company cannot predict the impact, if any, that any of the matters described above for the period ended September 30, 2011 may have on its business, results of operations, financial position, or cash flows. Because of the inherent uncertainties of such matters, the Company cannot estimate the range of possible losses from them.

In addition to the above cases, from time to time, the Company may be involved in various legal proceedings arising in the ordinary course of business.  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.

Note 7 — Acquisition

On April 25, 2011, the Company acquired Tiny Prints, Inc. (“Tiny Prints”), a privately-held ecommerce company.  Pursuant to the terms of the agreement, all of the outstanding shares of capital stock of Tiny Prints, together with vested and unvested Tiny Prints equity awards, were acquired by the Company for aggregate consideration comprised of (i) approximately $146.0 million in cash, and approximately 4.0 million shares of the Company’s common stock issuable in exchange for shares of Tiny Prints capital stock and (ii) Company equity awards for approximately 1.4 million shares of common stock in exchange for vested and unvested Tiny Prints’ equity awards assumed by the Company, in each case pursuant and subject to the terms of the Merger Agreement. The 5.4 million shares of Shutterfly common stock issuable pursuant to the agreement equal approximately 18.5% of the Company’s outstanding common stock as of March 30, 2011.

During the nine months ended September 30, 2011, the Company finalized the Net Working Capital, Net Cash, and Net Debt amounts resulting in a reduction of purchase price of approximately $1.3 million.  In accordance with the merger agreement, this amount will be repaid from the consideration held in escrow in the same proportion of cash and stock as was made in the initial escrow contribution.  As of September 30, 2011, the cash proceeds due from escrow have been accrued as a component of other current assets.
 
Purchase Price
 
The total purchase price, after adjusting for changes in Net Working Capital, Net Cash, and Net Debt, is as follows (in thousands):
 
Cash consideration
 
$
146,040
 
Fair value of common stock issued
 
 
218,557
 
Fair value of vested stock awards assumed
 
 
41,766
 
Total fair value of consideration transferred
 
$
406,363
 
 
Tiny Prints operates tinyprints.com and weddingpaperdivas.com which offer cards, invitations, personalized stationery and photo books.  With the acquisition and combined resources, the Company expects to incur significant revenue and cost synergies through the Tiny Prints brands, customer base and workforce.
 
Estimated Fair Value of Stock Awards Assumed

In connection with the acquisition, each Tiny Prints stock option that was outstanding and unexercised was assumed and converted into an option to purchase the Company’s common stock based on a conversion ratio of 0.327, which was calculated as the consideration price per share of $12.44 divided by a fixed per share value of $38. The Company assumed the stock options in accordance with the terms of the applicable Tiny Prints stock option plan and the stock option agreement. Based on Tiny Prints’ stock options outstanding at April 25, 2011, the Company converted options to purchase approximately 4.1 million shares of Tiny Prints common stock into options to purchase approximately 1.3 million shares of the Company’s common stock. The Company also assumed and converted approximately 196,896 unvested shares of outstanding Tiny Prints restricted stock units into approximately 64,386 shares of the Company’s restricted stock units, using the same conversion ratios stated above.
 
 
SHUTTERFLY, INC.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

The fair value of stock options assumed was calculated using a Black-Scholes valuation model with the following assumptions: closing date market price of $54.64 per share; expected term of 4.5 years; risk-free interest rate of 2.1%; expected volatility of 48.1%; and no dividend yield. The fair value of restricted stock units assumed was calculated using the closing date market price of $54.64 per share for the Company’s common stock. The Company included the fair value of vested stock options assumed of $41.8 million in the consideration transferred for the acquisition. The estimated fair value of unvested stock options and restricted stock units assumed by the Company of $25.8 million was not included in the consideration transferred and is being recognized as stock-based compensation expense over the weighted average remaining vesting period of approximately two years. In addition, the Company determined that $2.9 million of incremental fair value was associated with vested awards at the acquisition date, and has recognized this additional amount in its post-combination financial statements.

Purchase Price Allocation

Under the purchase accounting method, the total purchase price was allocated to Tiny Prints’ tangible and identifiable intangible assets acquired and liabilities assumed based upon their estimated fair values as of the April 25, 2011 closing date of the acquisition. The excess purchase price over the value of the net assets acquired is recorded as goodwill.

The purchase price of Tiny Prints is allocated as follows (in thousands):

 
 
Amount
 
 
Estimated Useful Life (in years)
 
 
 
 
 
 
 
 
 
 
Total assets acquired
 
$
19,235
 
 
 
N/A
 
Total liabilities assumed
 
 
(44,118
)
 
 
N/A
 
Identifiable intangible assets:
 
 
 
 
 
 
 
 
Trade name
 
 
51,100
 
 
 
15
 
Customer base
 
 
33,300
 
 
 
7
 
Developed technology
 
 
12,500
 
 
 
4
 
Other
 
 
3,080
 
 
 
2-3
 
Goodwill
 
 
331,266
 
 
 
N/A
 
Total purchase price
 
$
406,363
 
 
 
 
 
 
Included in the total liabilities assumed is a net deferred tax liability balance of $32.2 million, primarily comprised of the difference between the assigned values of the tangible and intangible assets acquired and the tax basis of those assets. This amount is net of deferred tax assets related to vested non-qualified stock options included in the purchase price, as well as other deferred tax assets acquired in the transaction.

Total amortizable intangible assets total $100.0 million and consist of trade name, customer base, developed technology, and other contractual agreements with useful lives that range from 2 to 15 years.

Goodwill of $331.3 million represents the excess of the purchase price over the fair value of the underlying net tangible and identifiable intangible assets, and represents the expected synergistic benefits of the transaction and the knowledge and experience of the workforce in place. In accordance with applicable accounting standards, goodwill will not be amortized but instead will be tested for impairment at least annually, or, more frequently if certain indicators are present. In the event that the management of the combined company determined that the value of goodwill has become impaired, the combined company will incur an accounting charge for the amount of the impairment during the fiscal quarter in which the determination is made.
 
 
The following table presents the pro forma statements of operations obtained by combining the historical consolidated operations of the Company and Tiny Prints for the three and nine months ended September 30, 2011 and 2010, giving effect to the merger as if it occurred on January 1, 2011 and 2010, respectively (in thousands, except per share data):

 
 
Three Months Ended
September 30,
 
 
Nine Months Ended
September 30,
 
 
 
2011
 
 
2010
 
 
2011
 
 
2010
 
Pro forma net revenues
 
$
76,523
 
 
$
62,144
 
 
$
235,294
 
 
$
182,113
 
Pro forma net loss
 
 
(9,953
)
 
 
(7,235
)
 
 
(24,322
)
 
 
(18,339
)
Pro forma basic and diluted net loss per share
 
$
(0.29
)
 
$
(0.27
)
 
$
(0.76
)
 
$
(0.68
)
 
      Included in net revenues for the three and nine months ended September 30, 2011 is $16.0 million and $30.7 million, respectively, of net revenues from sales of Tiny Prints products from the acquisition date of April 25, 2011 through September 30, 2011.
 
 
14

 
 

CAUTIONARY NOTE REGARDING FORWARD-LOOKING STATEMENTS

This document, including the following Management’s Discussion and Analysis of Financial Condition and Results of Operations, contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934 that are based upon our current expectations. These forward-looking statements include statements related to our expectations regarding the seasonality and growth of our business, the impact on us of general economic conditions, trends in key metrics such as number of customers and orders and average order value, the decline in average selling prices for prints, our capital expenditures for 2011, the sufficiency of our cash and cash equivalents and cash generated from operations for the next 12 months, our ability to grow our personalized products and services as a percentage of our total revenues, our operating expenses remaining a consistent percentage of our net revenues, as well as other statements regarding our future operations, financial condition and prospects and business strategies. In some cases, you can identify forward-looking statements by terminology such as “project,” “believe,” “anticipate,” “plan,” “expect,” “estimate,” “intend,” “continue,” “should,” “would,” “could,” “potentially,” “will,” or “may,” or the negative of these terms or other comparable terminology. Forward-looking statements involve risks and uncertainties. Our actual results and the timing of events could differ materially from those anticipated in our forward-looking statements as a result of many factors, including but not limited to, the seasonality of our business, whether we are able to expand our customer base and increase our product and service offering, competition in our marketplace and the other risks set forth below under “Risk Factors” in Part II, Item 1A of this report. Given these risks and uncertainties, readers are cautioned not to place undue reliance on such forward-looking statements. We assume no obligation to update any of the forward-looking statements after the date of this report or to compare these forward-looking statements to actual results.

Overview

We are an Internet-based social expression and personal publishing service that enables consumers to share, print and preserve their memories by leveraging our technology, manufacturing, web-design and merchandising capabilities.  Our vision is to make the world a better place by helping people share life’s joy. Our mission is to build an unrivaled service that enables deeper, more personal relationships between our customers and those who matter most in their lives.  Our primary focus is on helping consumers manage their memories through the powerful medium of photography. We provide a full range of personalized photo-based products and services that make it easy, convenient and fun for consumers to upload, edit, enhance, organize, find, share, create, print, and preserve their memories in a creative and thoughtful manner.

On April 25, 2011, we acquired Tiny Prints, Inc. a privately-held company based in Sunnyvale, California that operates tinyprints.com and weddingpaperdivas.com, two growing ecommerce brands offering stylish cards, invitations, personalized stationary and photo books. We believe the acquisition will accelerate growth in our cards and stationery offering and will also provide the opportunity for significant synergies through vertical integration.

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

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

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

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

Net Revenues.      Our net revenues are comprised of sales generated from personalized products and services (“PPS”), prints and commercial print services.

Personalized products and services
 
Our personalized products and services revenues are derived from the sale of photo-based products, such as photo books, greeting and stationery cards, calendars and other photo-based merchandise and the related shipping revenues. Greeting and stationery card revenue includes all products sold by Tiny Prints.  Included in our photo-based merchandise are items such as mugs, mouse pads, desktop plaques and puzzles. Revenue from advertising displayed on our website and referral fees are also included in PPS revenue.  Our referral fees were approximately 0.7%, 2.5% and 3.1% of our net annual revenues for 2010, 2009 and 2008.  Our referral fee program was discontinued effective March 31, 2010, and no referral fee revenue has been recorded subsequent to that date.

Prints
 
We also generate revenue from photo prints and the associated shipping revenue.  Photo prints consist of wallet, 4x6, 5x7, 8x10, and large format sizes.  Also included in print revenues are photocards, which are personalized silver halide photo prints with designed content, used for greeting card occasions ranging from holidays to birthday cards and thank you notes.

Commercial print services
 
In order to use available print capacity during low volume periods and to leverage our large installed base of existing digital presses, we began providing commercial printing services in 2008 to the direct marketing industry. We continue to focus our efforts in expanding our presence in this market.

All of our consumer revenue is recorded net of estimated returns, promotions redeemed by customers and other discounts. Customers place orders through our website and pay primarily using credit cards.  Advertising and commercial print customers are invoiced upon fulfillment.

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

To further understand net revenue trends, we monitor several key metrics including:

Total Customers.    We closely monitor total customers as a key indicator of demand.  Total customers include the number of transacting customers in a given period.  We seek to expand our customer base by empowering our existing customers with sharing and collaboration services (such as Shutterfly Gallery and Shutterfly Share Sites), and by conducting integrated marketing and advertising programs.  Total customers have increased on an annual basis for each year since inception and while we expect this trend to continue, the number of customers is dependent on whether we are successful in executing our strategy in addition to the conditions of the overall economic environment.

Total Number of Orders.    We closely monitor the total number of orders as a leading indicator of net revenue trends. We recognize the net revenues associated with an order when the products have been shipped and all other revenue recognition criteria have been met.  Orders are typically processed and shipped within two business days after a customer places an order. Total number of orders has increased on an annual basis for each year since 2000, and while we anticipate this trend to continue in the future, the number of orders is dependent on whether we are successful in executing our strategy in addition to the conditions of the overall economic environment.
 
 
Average Order Value.     For Shutterfly, average order value is net revenues, excluding revenues from our commercial print services, for a given period divided by the total number of customer orders recorded during that same period. For Tiny Prints, average order value excludes the impact of orders and net revenues related to sales of individual greeting cards, referred to as one-to-one greeting cards. We seek to increase average order value as a means of increasing net revenues. Average order value has increased on an annual basis for each year since 2000, and we anticipate that this trend will continue in the future as consumers shift from prints into personalized products and services.
 
Personalized Products and Services Revenues as Percentage of Net Revenues.    We continue to innovate and improve our personalized products and services and expect the net revenues from these products and services to increase as a percentage of total net revenues as we continue to diversify our product offerings.  Personalized products and services as a percentage of total net revenue was 71% in 2010, 66% in 2009 and 61% in 2008.  We believe that this trend results, in part, from the shift of consumer spending from offline to online outlets, as well as the increasing adoption of personalized, designed content.

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

Cost of Net Revenues.      Cost of net revenues consists primarily of direct materials (the majority of which consists of paper, ink, and photo book covers), payroll and related expenses for direct labor, shipping charges, packaging supplies, distribution and fulfillment activities, rent for production facilities, depreciation of production equipment, and third-party costs for photo-based merchandise. Cost of net revenues also includes payroll and related expenses for personnel engaged in customer service, any third-party software or patents licensed, as well as the amortization of acquired developed technology, capitalized website and software development costs, and patent royalties.  Cost of net revenues also includes certain costs associated with facility closures and restructuring.

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

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

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

General and administrative expense includes general corporate costs, such as rent for our corporate offices, insurance, depreciation on information technology equipment, and legal and accounting fees. Transaction costs related to our acquisition of Tiny Prints 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.   We recognized a final payment due from one of the agreements in the first quarter of fiscal year 2010.

Interest Expense.      Interest expense consists of interest costs recognized under our capital lease obligations as well as costs associated with our line of credit facility that expired in June 2010 and was not renewed.

Interest and other income, net.   Interest and other income, net primarily consists of the interest earned on our cash and investment accounts.  In 2010, this also included gains and losses on our trading securities, our auction-rate securities ("ARS") investment, which we liquidated in July 2010.

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. Historically, we have only been subject to taxation in the United States because we only operate within the United States.
 

  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, 2010.
 
Results of Operations

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

 
 
Three Months Ended
 
 
Nine Months Ended
 
 
 
September 30,
 
 
September 30,
 
 
 
2011
 
 
2010
 
 
2011
 
2010
 
Net revenues
 
 
100
%
 
 
100
%
 
 
100
%
 
 
100
%
Cost of net revenues
 
 
54
%
 
 
51
%
 
 
53
%
 
 
50
%
Gross profit
 
 
46
%
 
 
49
%
 
 
47
%
 
 
50
%
Operating expenses:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Technology and development
 
 
24
%
 
 
24
%
 
 
23
%
 
 
26
%
Sales and marketing
 
 
33
%
 
 
23
%
 
 
31
%
 
 
23
%
General and administrative
 
 
19
%
 
 
18
%
 
 
20
%
 
 
19
%
Loss from operations
 
 
(30
)%
 
 
(16
)%
 
 
(27
)%
 
 
(18
)%
Interest expense
 
 
0
%
 
 
0
%
 
 
0
%
 
 
0
%
Interest and other income, net
 
 
0
%
 
 
0
%
 
 
0
%
 
 
0
%
Loss before income taxes
 
 
(30
)%
 
 
(16
)%
 
 
(27
)%
 
 
(18
)%
Benefit from income taxes
 
 
17
%
 
 
6
%
 
 
17
%
 
 
7
%
Net loss
 
 
(13
)%
 
 
(10
)%
 
 
(10
)%
 
 
(11
)%
 
Comparison of the Three Month Periods Ended September 30, 2011 and 2010
 
 
 
Three Months Ended September 30,
 
 
 
2011
   
2010
   
$ Change
   
% Change
 
 
 
(in thousands)
 
Net revenues
 
 
   
 
   
 
   
 
 
Personalized products and services
  $ 56,528     $ 32,699     $ 23,829       73 %
Prints
    16,083       15,688       395       3  
Commercial printing services
    3,912       571       3,341       585  
Total net revenues
    76,523       48,958       27,565       56  
Cost of net revenues
    41,647       24,906       16,741       67  
Gross profit
  $ 34,876     $ 24,052     $ 10,824       45 %
Percentage of net revenues
    46 %     49 %            

Net revenues increased $27.6 million, or 56%, for the three months ended September 30, 2011 as compared to the same period in 2010.  Revenue growth was attributable to increases in all revenue categories.   PPS revenues increased $23.8 million, or 73%, to $56.5 million in the three months ended September 30, 2011 compared to the same period in 2010. The increase in PPS is primarily a result of increased sales of photo books and greeting and stationery cards, including sales from our Tiny Prints and Wedding Paper Divas brands.   Print revenue increased $0.4 million, or 3%, to $16.1 million in the three months ended September 30, 2011 compared to the same period in 2010.  Print revenues from sales of 4x6 prints represented 12% of total net revenues for the three months ended September 30, 2011, versus 18% in the prior year.   In terms of product mix, PPS represented 74% and Prints represented 21% of revenue in the three months ended September 30, 2011.  This compares to 67% and 32% in the same period in 2010.    Revenue from our commercial print services increased $3.3 million, or 585%, to $3.9 million for the three months ended September 30, 2011, compared to the same period in 2010, and represented 5% of our total net revenues in the three months ended September 30, 2011.
 
 
For Shutterfly and Tiny Prints, net revenue increases were also the result of year-over-year increases in each of our key metrics: customers, orders, and average order value, as noted below:

 
 
Three Months Ended September 30,
 
 
 
2011
   
2010
   
$ Change
   
% Change
 
Shutterfly
 
(in thousands, except AOV amounts)
 
Customers
    1,440       1,246       194       16 %
Orders
    2,388       2,037       351       17 %
Average order value (excluding commercial print revenues)
  $ 23.71     $ 23.75     $ (0.04 )     0 %
 
 
 
Three Months Ended September 30,
 
   
2011
   
2010
   
$ Change
   
% Change
 
Tiny Prints
 
(in thousands, except AOV amounts)
 
Customers
    144       136       8       6 %
Orders
    189       168       21       12 %
Average order value (excluding one-to-one greeting cards)
  $ 103.82     $ 89.33     $ 14.49       16 %

Cost of net revenues increased $16.7 million, or 67%, for the three months ended September 30, 2011 as compared to the same period in 2010. As a percentage of net revenues, cost of net revenues increased to 54% in 2011 from 51% in 2010, which decreased gross margin to 46% in the three months ended September 30, 2011 from 49% in the same period in 2010. Overall, the increase in cost of net revenues was primarily the result of the increased volume of shipped products, increased headcount and greater third-party fulfillment costs associated with Tiny Prints products. These costs were partially offset by favorable improvements from product mix.

 
 
Three Months Ended September 30,
 
 
 
2011
 
 
2010
 
 
$ Change
 
 
% Change
 
 
 
(in thousands)
 
Technology and development
 
$
18,106
 
 
$
11,602
 
 
$
6,504
 
 
 
56
%
Percentage of net revenues
 
 
24
%
 
 
24
%
 
 
-
 
 
 
-
 
Sales and marketing
 
$
25,252
 
 
$
11,500
 
 
$
13,752
 
 
 
120
%
Percentage of net revenues
 
 
33
%
 
 
23
%
 
 
-
 
 
 
-
 
General and administrative
 
$
14,210
 
 
$
8,927
 
 
$
5,283
 
 
 
59
%
Percentage of net revenues
 
 
19
%
 
 
18
%
 
 
-
 
 
 
-
 

Our technology and development expense increased $6.5 million, or 56%, for the three months ended September 30, 2011, as compared to the same period in 2010. As a percentage of net revenues, technology and development expense remained flat at 24%. The increase in technology and development expense was primarily due to an increase of $3.4 million related to personnel and related costs for employees, $1.7 million of stock-based compensation, $0.8 million related to professional and outside services consultants involved with website development and website infrastructure support teams and $0.7 million related to facilities costs.

At September 30, 2011, headcount in technology and development increased by 59% compared to September 30, 2010 reflecting our strategic focus to increase the rate of innovation in our product and services offerings, to generate greater differentiation from our competitors, and improve our long-term operating efficiency.  In addition, the increase in headcount is also the result of the completion of the Tiny Prints acquisition during the year. In the three months ended September 30, 2011, we capitalized $2.4 million in eligible salary and consultant costs, including $0.1 million of stock based compensation, associated with software developed or obtained for internal use, compared to $2.4 million, which included $0.1 million of stock based compensation capitalized in the three months ended September 30, 2010.

Our sales and marketing expense increased $13.8 million, or 120%, in the three months ended September 30, 2011 compared to the same period in 2010.  As a percentage of net revenues, total sales and marketing expense increased to 33% in the three months ended September 30, 2011 from 23% in the three months ended September 30, 2010. The increase in sales and marketing expense was primarily due to an increase of $5.7 million related to expanded online marketing and partner marketing campaigns, as well as an increase of $2.5 million for depreciation, $2.4 million in stock-based compensation, and $0.3 million in professional fees.  Personnel and related costs increased $2.8 million due to the additional headcount from our acquisition of Tiny Prints as well as the expansion of our existing marketing team.

Our general and administrative expense increased $5.3 million, or 59%, in the three months ended September 30, 2011 as compared to the same period in 2010.  As a percentage of net revenues, total general and administrative expense increased slightly to 19% in the three months ended September 30, 2011 from 18% in the three months ended September 30, 2010. The increase in general and administrative expense is primarily due to an increase in personnel related costs of $1.7 million as a result of increased headcount, an increase in stock-based compensation of $1.5 million, $0.6 million in professional fees, and $0.4 million related to facility costs.  In the three months ended September 30, 2011, we also incurred an increase in credit card fees of $0.6 million which was driven by the increase in consumer product revenue as compared to the same period in 2010.
 

 
 
Three Months Ended September 30,
 
 
 
2011
 
 
2010
 
 
Change
 
 
 
(in thousands)
 
Interest expense
 
$
-
 
 
$
-
 
 
$
-
 
Interest and other income, net
 
$
5
 
 
$
26
 
 
$
(21
)
 
  Interest and other income, net decreased by $21,000 for the three months ended September 30, 2011 as compared to the same period in 2010.
 
 
 
Three Months Ended
September 30,
 
   
2011
   
2010
 
   
(in thousands)
 
Income tax benefit
  $ 12,734     $ 3,181  
Effective tax rate
    56 %     40 %

The benefit for income taxes was $12.7 million for the three months ended September 30, 2011, compared to a benefit of $3.2 million for the three months ended September 30, 2010.  Our effective tax rate was 56% in the three months ended September 30, 2011, compared to 40% in the same period in 2010, primarily reflecting non-deductible stock-based compensation and transaction expenses, offset by tax benefits resulting from disqualifying dispositions of employee incentive stock options during the period plus additional benefits related to research and development tax credits from prior year.
 
 
 
Three Months Ended September 30,
 
 
 
2011
   
2010
   
$ Change
   
% Change
 
 
 
(in thousands)
 
Loss before income taxes
  $ (22,687 )   $ (7,951 )   $ (14,736 )     185 %
Net loss
  $ (9,953 )   $ (4,770 )   $ (5,183 )     109  %
Percentage of net revenues
    (13 )%     (10 )%      —        

 Net loss increased by $5.2 million for the three months ended September 30, 2011 as compared to the same period in 2010. As a percentage of net revenue, net loss was 13% and 10% for the three months ended September 30, 2011 and September 30, 2010, respectively.

Comparison of the Nine Month Period Ended September 30, 2011 and 2010

 
 
Nine Months Ended September 30,
 
 
 
2011
   
2010
   
$ Change
   
% Change
 
 
 
(in thousands)
 
Net revenues
 
 
   
 
   
 
   
 
 
Personalized products and services
  $ 155,858     $ 94,870     $ 60,988       64 %
Prints
    44,727       43,795       932       2  
Commercial printing services
    8,931       2,842       6,089       214  
Total net revenues
    209,516       141,507       68,009       48  
Cost of net revenues
    111,074       70,663       40,411       57  
Gross profit
  $ 98,442     $ 70,844     $ 27,598       39 %
Percentage of net revenues
    47 %     50 %            
 
Net revenues increased $68.0 million, or 48%, for the nine months ended September 30, 2011 as compared to the same period in 2010.  Revenue growth was attributable to increases in all revenue categories.   PPS revenues increased $61.0 million, or 64%, to $155.9 million in the nine months ended September 30, 2011 compared to the same period in 2010. The increase in PPS is primarily a result of increased sales of photo books and greeting and stationery cards, including sales from our Tiny Prints and Wedding Paper Divas brands. Print revenue increased $0.9 million, or 2%, to $44.7 million in the nine months ended September 30, 2011 compared to the same period in 2010.  The overall increase in print revenue was primarily due to an increase in large format prints offset by a decrease in 4x6 print revenue, which represented 11% of total net revenues versus 17% in the prior year.   In terms of product mix, PPS represented 75% and Prints represented 21% of revenue in the three months ended September 30, 2011.  This compares to 67% and 32% in the same period in 2010.    Revenue from our commercial print services increased $6.1 million, or 214%, to $8.9 million for the nine months ended September 30, 2011, compared to the same period in 2010, and represented 4% of our total net revenues in the nine months ended September 30, 2011.
 
 
Cost of net revenues increased $40.4 million, or 57%, for the nine months ended September 30, 2011 as compared to the same period in 2010. As a percentage of net revenues, cost of net revenues increased slightly to 53% in 2011 from 50% in 2010, which decreased gross margin to 47% in the nine months ended September 30, 2011 from 50% in the same period in 2010. Overall, the increase in cost of net revenues was primarily the result of the increased volume of shipped products and increased headcount, as well as additional third party fulfillment costs associated with Tiny Prints products. These costs were partially offset by favorable improvements from product mix.
 
 
 
Nine Months Ended September 30,
 
 
 
2011
   
2010
   
$ Change
   
% Change
 
 
 
(in thousands)
 
Technology and development
  $ 48,190     $ 36,248     $ 11,942       33 %
Percentage of net revenues
    23 %     26 %     -       -  
Sales and marketing
  $ 64,447     $ 32,968     $ 31,479       95 %
Percentage of net revenues
    31 %     23 %     -       -  
General and administrative
  $ 43,023     $ 27,348     $ 15,675       57 %
Percentage of net revenues
    20 %     19 %     -       -  
 
Our technology and development expense increased $11.9 million, or 33%, for the nine months ended September 30, 2011, as compared to the same period in 2010. As a percentage of net revenues, technology and development expense decreased to 23% for the nine months ended September 30, 2011 from 26% for the same period in 2010. The increase in technology and development expense was primarily due to an increase of $7.3 million related to personnel and related costs for employees, $3.8 million of stock-based compensation, an increase of $3.1 million related to professional and outside services consultants involved with website development and website infrastructure support teams, and $1.6 million related to facilities costs.  These factors were partially offset by a decrease in depreciation expense of $1.7 million and higher website development costs capitalized in the current period compared to the same period in the prior year.

In the nine months ended September 30, 2011, we capitalized $7.1 million in eligible salary and consultant costs, including $0.3 million of stock based compensation, associated with software developed or obtained for internal use, compared to $4.6 million, which included $0.2 million of stock based compensation capitalized in the nine months ended September 30, 2010.  We expect this trend to continue in 2011, further increasing capitalized website and software development costs as a percentage of our total capital expenditures.

Our sales and marketing expense increased $31.5 million, or 95%, in the nine months ended September 30, 2011 compared to the same period in 2010.  As a percentage of net revenues, total sales and marketing expense increased to 31% from 23%. The increase in sales and marketing expense was primarily due to an increase of $14.1 million related to expanded online marketing and partner marketing campaigns.  The increase is also attributable to an increase of $6.2 million in personnel and related costs associated with our acquisition of Tiny Prints as well as the expansion of our internal marketing team, an increase of $5.8 million in stock based compensation, $4.6 million in depreciation and $0.7 million for professional fees.

Our general and administrative expense increased $15.7 million, or 57%, in the nine months ended September 30, 2011 as compared to the same period in 2010.  As a percentage of net revenues, total general and administrative expense increased to 20% in the nine months ended September 30, 2011 from 19% for the comparable period in 2010. The increase in general and administrative expense is primarily due to an increase in personnel related costs of $4.7 million as a result of increased headcount, $4.2 million in stock-based compensation, $2.0 million in professional fees, and $0.8 million for facility costs.  In the nine months ended September 30, 2011, we also incurred an increase in credit card fees of $1.7 million, which was driven by the increase in consumer product revenue as compared to the same period in 2010.  During the nine months ended September 30, 2010, we received the final installment from a cross-licensing agreement, while in the current period we received no installments. These payments were recognized as reductions of general and administrative expense.

 
 
Nine Months Ended September 30,
 
 
 
2011
 
 
2010
 
 
Change
 
 
 
(in thousands)
 
Interest expense
 
$
-
 
 
$
(42
)
 
$
(42
)
Interest and other income, net
 
$
25
 
 
$
462
 
 
$
(437
)

Interest expense decreased in the nine months ended September 30, 2011 as compared to the same period in 2010 primarily due to the expiration of our $20.0 million line of credit facility with Silicon Valley Bank on June 23, 2010, which we did not renew.
 
Interest and other income, net decreased by $0.4 million for the nine months ended September 30, 2011 compared to the same period in 2010. The decrease was primarily due to the liquidation of our ARS investments on July 1, 2010, which yielded higher returns and were subsequently invested in Treasury securities, which yielded lower returns.
 
   
Nine Months Ended September 30,
 
   
2011
 
2010
 
   
(in thousands)
 
Income tax benefit
  $ 35,830     $ 9,914  
Effective tax rate
    63 %     39 %
 
 
The benefit for income taxes was $35.8 million for the nine months ended September 30, 2011, compared to a benefit of $9.9 million for the nine months ended September 30, 2010.  Our effective tax rate was 63% in the nine months ended September 30, 2011, compared to 39% in the same period in 2010, primarily reflecting non-deductible stock-based compensation and transaction expenses, offset by tax benefits resulting from disqualifying dispositions of employee incentive stock options during the period plus additional benefits related to research and development tax credits from prior year.
 
 
 
Nine Months Ended September 30,
 
 
 
2011
   
2010
   
$ Change
   
% Change
 
   
(in thousands)
 
Loss before income taxes
  $ (57,193 )   $ (25,300 )   $ (31,893 )     126 %
Net loss
  $ (21,363 )   $ (15,386 )   $ (5,977 )     39 %
Percentage of net revenues
    (10 )%     (11 )%            
 
Net loss increased by $6.0 million for the nine months ended September 30, 2011 as compared to the same period in 2010. As a percentage of net revenue, net loss was 10% and 11% for the nine months ended September 30, 2011 and September 30, 2010, respectively.

 Liquidity and Capital Resources
 
 
 
Nine Months Ended
September 30,
 
 
 
2011
   
2010
 
   
(in thousands)
 
Consolidated Statements of Cash Flows Data:
 
 
   
 
 
Purchases of property and equipment
  $ 16,319     $ 11,532  
Capitalization of software and website development costs
    7,877       4,608  
Depreciation and amortization
    24,526       20,290  
Cash flows used in operating activities
    (59,591 )     (17,892 )
Cash flows provided by (used in) investing activities
    (157,906 )     31,851  
Cash flows provided by financing activities
    33,963       13,741  

We anticipate that our current cash and cash equivalents balances and cash generated from operations will be sufficient to meet our strategic and working capital requirements, lease obligations, expansion plans, and technology development projects for at least the next twelve months. Whether these resources are adequate to meet our liquidity needs beyond that period will depend on our growth, operating results and the capital expenditures required to meet possible increased demand for our products. If we require additional capital resources to grow our business internally or to acquire complementary technologies and businesses at any time in the future, we may seek to obtain additional debt or equity financing. The sale of additional equity could result in additional dilution to our stockholders. Financing arrangements may not be available to us, or may not be in amounts or on terms acceptable to us.
 
We anticipate that total 2011 capital expenditures will range from 7.0% to 7.5% of our expected net revenues in 2011.  These expenditures will be used to purchase technology and equipment to support the growth in our business and to increase our production capacity and help enable us to respond more quickly and efficiently to customer demand. An increasing component of these expenditures includes costs associated with capitalized software and website development, as we continue to support our innovative engineering and product development strategies.
 
The following table shows total capital expenditures by category for the nine months ended September 30, 2011 and 2010 (in thousands):

 
 
Nine Months Ended
September 30,