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EX-32.01 - EXHIBIT 32.01 - SHUTTERFLY INCex32_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 June 30, 2010
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 o     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 July 28, 2010
Common stock, $0.0001 par value per share
27,271,428

 
 

 
 
TABLE OF CONTENTS

 
Page
Number
Part I - Financial Information
 
Item 1. Financial Statements
 
3
4
5
6
13
24
24
Part II - Other Information
 
25
25
38
38
38
39
40
Index to Exhibits 41
EXHIBIT 10.01  
 
 
 
 

 
PART IFINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

Item 1. Condensed Consolidated Financial Statements

SHUTTERFLY, INC.
CONDENSED CONSOLIDATED BALANCE SHEET
(In thousands, except par value amounts)
(Unaudited)
 
 
 
June 30,
2010
   
December 31,
2009
 
ASSETS
 
       
 
Current assets:
 
       
 
Cash and cash equivalents
 
$
132,602
   
$
132,812
 
Short-term investments
 
 
26,350
     
47,925
 
Accounts receivable, net
 
 
2,959
     
5,472
 
Inventories
 
 
2,484
     
2,968
 
Deferred tax asset, current portion
 
 
2,747
     
2,243
 
Prepaid expenses and other current assets
 
 
12,406
     
4,501
 
Total current assets
 
 
179,548
     
195,921
 
Property and equipment, net
 
 
40,827
     
41,845
 
Goodwill and intangible assets, net
 
 
12,464
     
13,406
 
Deferred tax asset, net of current portion
 
 
17,455
     
14,674
 
Other assets
 
 
5,177
     
5,467
 
Total assets
 
$
255,471
   
$
271,313
 
LIABILITIES AND STOCKHOLDERS’ EQUITY
 
           
 
Current liabilities:
 
           
 
Accounts payable
 
$
7,143
   
$
13,116
 
Accrued liabilities
 
 
12,810
     
32,793
 
Deferred revenue
 
 
8,256
     
8,602
 
Total current liabilities
 
 
28,209
     
54,511
 
Other liabilities
 
 
2,568
     
1,638
 
Total liabilities
 
 
30,777
     
56,149
 
Commitments and contingencies (Note 6)
 
           
 
Stockholders’ equity
 
           
 
Common stock, $0.0001 par value; 100,000 shares authorized; 27,213 and 25,909 shares issued and outstanding on June 30, 2010 and December 31, 2009, respectively
 
3
     
3
 
Additional paid-in capital
 
 
246,556
     
226,410
 
Accumulated deficit
 
 
(21,865
)
   
(11,249
)
Total stockholders' equity
 
 
224,694
     
215,164
 
Total liabilities and stockholders' equity
 
$
255,471
   
$
271,313
 
 

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

 
CONDENSED CONSOLIDATED STATEMENT OF OPERATIONS
(In thousands, except per share amounts)
(Unaudited)

 
 
Three Months Ended
   
Six Months Ended
 
 
 
June 30,
   
June 30,
 
 
 
2010
   
2009
   
2010
   
2009
 
 
                       
Net revenues
  $ 46,807     $ 38,858     $ 92,549     $ 74,870  
Cost of net revenues
    23,179       20,069       45,757       39,741  
Gross profit
    23,628       18,789       46,792       35,129  
Operating expenses:
                               
Technology and development
    12,477       10,963       24,646       21,957  
Sales and marketing
    11,311       8,901       21,468       16,698  
General and administrative
    9,620       8,333       18,421       15,279  
Total operating expenses
    33,408       28,197       64,535       53,934  
Loss from operations
    (9,780 )     (9,408 )     (17,743 )     (18,805 )
Interest expense
    (21 )     (27 )     (42 )     (114 )
Interest and other income, net
    194       283       436       607  
Loss before income taxes
    (9,607 )     (9,152 )     (17,349 )     (18,312 )
Benefit from income taxes
    3,722       3,497       6,733       6,426  
Net loss
  $ (5,885 )   $ (5,655 )   $ (10,616 )   $ (11,886 )
 
                               
 
                               
Net loss per share - basic and diluted
  $ (0.22 )   $ (0.22 )   $ (0.40 )   $ (0.47 )
 
                               
Weighted-average shares outstanding - basic and diluted
    26,952       25,246       26,595       25,197  
 
                               
 
                               
Stock-based compensation is allocated as follows:
                         
 
                               
Cost of net revenues
  $ 129     $ 82     $ 260     $ 178  
Technology and development
    756       582       1,557       1,214  
Sales and marketing
    966       757       2,068       1,473  
General and administrative
    2,208       1,413       4,548       2,773  
 
 
The accompanying notes are an integral part of these condensed consolidated financial statements.

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

 
 
Six Months Ended
June 30,
 
 
 
2010
   
2009
 
Cash flows from operating activities:
 
 
   
 
 
Net loss
  $ (10,616 )   $ (11,886 )
Adjustments to reconcile net loss to net cash used in operating activities:
               
Depreciation and amortization
    12,680       12,544  
Amortization of intangible assets
    1,289       941  
Stock-based compensation, net of forfeitures
    8,433       5,638  
Loss/(gain) on disposal of property and equipment
    (88 )     79  
Deferred income taxes
    (3,285 )     (269 )
Tax benefit/(charge) from stock-based compensation
    3,710       (183 )
Excess tax benefits from stock-based compensation
    (4,102 )     -  
Changes in operating assets and liabilities:
               
Accounts receivable, net
    2,575       2,789  
Inventories
    484       873  
Prepaid expenses and other current assets
    (7,905 )     (5,759 )
Other assets
    (58 )     (3,009 )
Accounts payable
    (6,727 )     (6,895 )
Accrued and other liabilities
    (19,207 )     (10,780 )
Deferred revenue
    (346 )     (494 )
Net cash used in operating activities
    (23,163 )     (16,411 )
Cash flows from investing activities:
               
Purchases of property and equipment
    (8,630 )     (6,102 )
Capitalization of software and website development costs
    (2,049 )     (1,938 )
Proceeds from the sale of equipment
    77       -  
Proceeds from the sale of auction rate securities
    21,575       50  
Net cash provided by (used in) investing activities
    10,973       (7,990 )
Cash flows from financing activities:
               
Principal payments of capital lease obligations
    (6 )     (62 )
Proceeds from issuance of common stock upon exercise of stock options
    7,884       869  
Excess tax benefits from stock-based compensation
    4,102       -  
Shares withheld for payment of employee's withholding tax liability
    -       (991 )
Net cash provided by (used in) financing activities
    11,980       (184 )
Net decrease in cash and cash equivalents
    (210 )     (24,585 )
Cash and cash equivalents, beginning of period
    132,812       88,164  
Cash and cash equivalents, end of period
  $ 132,602     $ 63,579  
 
               
Supplemental schedule of non-cash investing activities
               
Net change in accrued purchases of property and equipment
  $ 914     $ (118 )

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

 
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 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 cards and stationery, calendars and photo books. 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 subsidiary. 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 six months ended June 30, 2010 are not necessarily indicative of the results that may be expected for the year ending December 31, 2010, or for any other period.

The December 31, 2009 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, 2009 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.

 
SHUTTERFLY, INC.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

Income Taxes

The Company accounts 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 and net operating loss and credit carryforwards using enacted tax rates in effect for the year in which the differences are expected to reverse. Valuation allowances are established when necessary to reduce deferred tax assets to the amounts expected to be realized.

The Company accounts for uncertain tax positions in accordance with the respective authoritative guidance. 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.

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 or penalties were accrued as of December 31, 2009 or June 30, 2010.

At June 30, 2010, the Company had $10.3 million of state net operating losses, associated with windfall tax benefits that will be recorded as additional paid-in capital when realized.  A tax windfall is created when the tax deduction associated with stock options exercised and vesting of restricted stock units exceeds the recognized stock-based compensation expense.  The Company is subject to taxation in California and other jurisdictions in the United States.

Recent Accounting Pronouncements

    Effective January 1, 2010, the Company adopted revised guidance intended to improve disclosures related to fair value measurements, issued by the Financial Accounting Standards Board ("FASB"). This guidance requires the Company to separate information about significant transfers in and out of Level 1 and Level 2 and the reason for such transfers, and also requires information related to purchases, sales, issuances, and settlements information of Level 3 financial assets to be included in the rollforward of activity. The guidance also requires the Company to provide certain disaggregated information on the fair value of financial assets and requires the Company to disclose valuation techniques and inputs used for both recurring and nonrecurring fair value measurements of our Level 2 and Level 3 financial assets. The Company has provided the additional required disclosures effective January 1, 2010.

Note 2 — Stock-Based Compensation

Stock Option Activity

A summary of the Company’s stock option activity for the three and six months ended June 30, 2010 is as follows (in thousands):
 
 
 
Number of Options Outstanding
   
Weighted Average Exercise Price
   
Weighted Average Contractual Term (Years)
   
Aggregate Intrinsic Value
 
Balances, December 31, 2009
    4,689     $ 13.88    
 
   
 
 
Granted
    63       19.69    
 
   
 
 
Exercised
    (526 )     10.49    
 
   
 
 
Forfeited, cancelled or expired
    (130 )     18.07    
 
   
 
 
Balances, March 31, 2010
    4,096     $ 14.29       6.5     $ 42,836  
Granted
    66       23.38                  
Exercised
    (186 )     12.78                  
Forfeited, cancelled or expired
    (87 )     23.09                  
Balances, June 30, 2010
    3,889     $ 14.32       6.4     $ 40,108  
Options vested and expected to vest at June 30, 2010
    3,683     $ 14.03       6.3     $ 38,936  
Options vested at June 30, 2010
    3,076     $ 13.00       6.0     $ 35,420  

 
SHUTTERFLY, INC.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

During the three months ended June 30, 2010, the Company granted options to purchase an aggregate of 66,000 shares of common stock with an estimated weighted-average grant-date fair value of $10.45 per share. The total intrinsic value of options exercised during the three months ended June 30, 2010, was $2.0 million.  Net cash proceeds from the exercise of stock options were $2.4 million and $7.9 million for the three and six months ended June 30, 2010, respectively.

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.  Expected volatility is based on the 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 six months ended June 30, 2010 and 2009, were as follows:
 
 
 
Three Months Ended
June 30,
   
Six Months Ended
June 30,
 
 
 
2010
   
2009
   
2010
   
2009
 
Dividend yield
                       
Annual risk free rate of return
    2.3 %     2.2 %     2.3 %     2.1 %
Expected volatility
    51.7 %     59.6 %     50.4 %     59.7 %
Expected term (years)
    4.5       4.6       4.6       4.6  

Employee stock-based compensation expense recognized in the three and six months ended June 30, 2010 and 2009, 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 two, 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 six months ended June 30, 2010, is as follows (in thousands):
 
 
 
Number of Units Outstanding
   
Weighted Average Grant Date Fair Value
 
Balances, December 31, 2009
    1,891     $ 10.48  
Granted
    717       19.46  
Vested
    (364 )     9.48  
Forfeited, cancelled or expired
    (61 )     10.60  
Balances, March 31, 2010
    2,183     $ 13.59  
Granted
    113       23.12  
Vested
    (228 )     13.87  
Forfeited, cancelled or expired
    (52 )     13.92  
Balances, June 30, 2010
    2,016     $ 14.08  

 
SHUTTERFLY, INC.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

Included in the RSU grants for the six months ended June 30, 2010, are 162,000 RSUs that have both performance and service vesting criteria (“PBRSU”).  The performance condition is tied to the Company’s future performance, and the service criteria are consistent with the vesting described in the Company's 2006 Equity Incentive Plan.  Compensation cost associated with these PBRSUs is recognized 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 June 30, 2010, the Company had $27,082,000 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 restricted common stock, common stock subject to repurchase rights, and 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 six months ended June 30, 2010 and 2009 is as follows (in thousands, except per share amounts):
 
 
 
Three Months Ended
 
Six Months Ended
 
 
June 30,
 
June 30,
 
 
2010
 
2009
 
2010
 
2009
 
Historical net loss per share:
 
 
   
 
   
 
   
 
 
Numerator
 
 
   
 
   
 
   
 
 
Net loss
  $ (5,885 )   $ (5,655 )   $ (10,616 )   $ (11,886 )
 
                               
Denominator for basic and diluted net loss per share
Weighted-average common shares outstanding
    26,952       25,246       26,595       25,197  
 
                               
Net loss per share — basic and diluted
  $ (0.22 )   $ (0.22 )   $ (0.40 )   $ (0.47 )

The following weighted-average outstanding stock options, restricted stock units, and shares subject to repurchase 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
   
Six Months Ended
 
 
 
June 30,
   
June 30,
 
 
 
2010
   
2009
   
2010
   
2009
 
Stock options, restricted stock units, and shares subject to repurchase
    5,981       6,888       6,213       6,807  
 

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 (cash equivalents and investments) as of June 30, 2010 (in thousands):
 
 
 
June 30, 2010
 
 
Fair Value
 
Level 1
 
Level 2
 
Level 3
 
Cash equivalents:
 
 
 
 
 
 
 
 
Money market funds
  $ 124,982     $ 124,982     $     $  
Short-term investments:
                               
Auction rate securities
    23,113                   23,113  
Rights on ARS securities
    3,237                   3,237  
Total financial assets
  $ 151,332     $ 124,982     $     $ 26,350  

Level 3 assets consist of auction rate securities (“ARS”) with an auction reset feature whose underlying assets are student loans that are substantially backed by the federal government. Because the auctions for these securities have continued to fail since February 2008, these investments are not currently trading and therefore do not have a readily determinable market value. Accordingly, the estimated fair value of the ARS no longer approximates par value.  The Company’s ARS investments are held by UBS AG ("UBS"), one of the Company’s investment providers. In November 2008, the Company accepted an offer (the “Right”) from UBS entitling the Company to sell at par value ARS purchased from UBS (approximately $26.3 million, par value) at anytime during a two-year period from June 30, 2010 through July 2, 2012.

The Company has valued the ARS and Right using a discounted cash flow model based on Level 3 assumptions.  As of June 30, 2010, the fair value of the ARS investments and Right were $23.1 million and $3.2 million, respectively.  The assumptions used in valuing the ARS and the Right include estimates of, based on data available as of June 30, 2010, interest rates, timing and amount of cash flows, credit and liquidity premiums, expected holding periods of the ARS and bearer risk associated with UBS's financial ability to repurchase the ARS beginning June 30, 2010.  At June 30, 2010, approximately 58% of these ARS investments were AAA-rated and 42% were AA-rated and all investments have continued to pay interest on schedule.

During the three and six months ended June 30, 2010, the Company liquidated ARS investments (at par value) of $21.2 million and $21.6 million, respectively, which were called by the state issuers.  The proceeds were subsequently invested in Treasury securities.

The following table provides a summary of changes in fair value of the Company’s ARS investments and the Right which are both Level 3 assets as of June 30, 2010 (in thousands):

 
 
Right
   
ARS
 
Balance at December 31, 2009
  $ 6,266     $ 41,659  
Sale of auction rate securities
    -       (21,575 )
Unrealized gain/(loss) included in earnings (Interest and other income, net)
    (3,029 )     3,029  
Balance at June 30, 2010
  $ 3,237     $ 23,113  

On June 30, 2010, the Company exercised the UBS Right to liquidate all of its ARS investments at par value. On July 1, 2010, that transaction was executed and the Company received proceeds of $26.3 million, which were immediately invested in Treasury securities.


SHUTTERFLY, INC.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

Note 5 — Balance Sheet Components

Property and Equipment

 
 
June 30,
2010
   
December 31,
2009
 
 
 
(in thousands)
 
Computer and other equipment
  $ 88,619     $ 84,754  
Software
    8,777       7,122  
Leasehold improvements
    6,861       6,848  
Furniture and fixtures
    2,984       2,956  
Capitalized software and website development costs
    19,662       17,494  
 
    126,903       119,174  
Less: Accumulated depreciation and amortization
    (86,076 )     (77,329 )
Net property and equipment
  $ 40,827     $ 41,845  

Property and equipment includes $35,000 and $1,212,000 of equipment under capital leases at June 30, 2010 and December 31, 2009, respectively. Accumulated depreciation relating to assets under capital leases totaled $27,000 and $1,199,000 at June 30, 2010 and December 31, 2009, respectively.

Depreciation and amortization expense totaled $6,307,000 and $6,294,000 for the three months ended June 30, 2010 and 2009, respectively.  Depreciation and amortization expense totaled $12,680,000 and $12,544,000 for the six months ended June 30, 2010 and 2009, respectively.

Accrued Liabilities
 
 
 
June 30,
 2010
   
December 31,
2009
 
 
 
(in thousands)
 
Accrued compensation
  $ 3,409     $ 5,227  
Accrued marketing expenses
    2,759       10,548  
Accrued income and sales taxes
    1,409       5,517  
Accrued production costs
    1,064       7,241  
Accrued purchases
    1,054       1,228  
Accrued other
    3,115       3,032  
 
  $ 12,810     $ 32,793  

 
SHUTTERFLY, INC.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

Note 6 — Commitments and Contingencies

Leases

The Company entered into a lease agreement for its Redwood City, California corporate buildings which commenced in March 2010 and will expire in 2017.  Rent expense is recorded on a straight-line basis over the lease term.  Because the lease provides for fixed escalations of the minimum rental payments, the difference between the straight-line rent charged to expense and the amount payable under the lease is recognized as deferred rent.

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.

Line of Credit

On June 23, 2010, the Company’s $20.0 million line of credit facility with Silicon Valley Bank expired, and was not renewed.  No amounts were drawn against the facility during its term.

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

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.

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

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 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 2010, the sufficiency of our cash and cash equivalents and cash generated from operations for the next 12 months and our ability to grow our personalized products and services as a percentage of our total 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.

We generate the majority of our revenues by producing and selling professionally-bound photo books, greeting cards and stationery, personalized calendars, other photo-based merchandise and high-quality prints ranging in size from wallet-sized to jumbo-sized 20x30 enlargements. We currently manufacture these items in our Charlotte, North Carolina and Phoenix, Arizona manufacturing facilities.  By controlling the production process in our own manufacturing 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 print and 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 fourth fiscal 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 brand.

 
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 ancillary products and services, and the related shipping revenues. Revenue from our advertising and sponsorship activities and referral fees are also included in PPS revenue.  Our referral fees have been approximately 3.0%, 3.1% and 2.5% of our net annual revenues for 2007, 2008, and 2009, respectively.  Our referral fee program was discontinued effective March 31, 2010, and no referral fee revenue has been recorded subsequent to that date.  As a result, we expect that our 2010 referral fee revenue will represent less than 1% of our full year 2010 net revenues.

Prints
We also generate revenue from photo prints and the associated shipping revenue.  Photo prints consist of wallet, 2x6, 4x6, 5x7, 8x10, photocards and large format sizes.

Commercial Print Services
In order to use available print capacity during low volume periods and to leverage our large installed base of digital presses, we began providing commercial print services in 2008. Our commercial print revenues are derived from the printing and shipping of direct marketing and other variable data print products and formats.  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 by 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 and revenue growth 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.

Average Order Value.   Average order value is net revenues, excluding revenues from our commercial print initiative, for a given period divided by the total number of customer orders recorded during that same period. 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.  As a result of discontinuing our referral fee program, effective March 31, 2010, we expect our average order value growth will moderate as a result of the decline in this revenue source.

Total Number of Orders.   We closely monitor 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, the conditions of the overall economic environment and a continued increase in consumer trends towards photo-based products.

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 56% in 2007, 61% in 2008 and 66% in 2009.

 
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 development costs, and patent royalties.  In addition, during the three and six months ended June 30, 2009, cost of net revenues includes certain costs associated with the closure of our Hayward manufacturing and production facility.

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, including rent for our corporate offices, insurance, depreciation on information technology equipment and legal and accounting fees. 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.

Interest and other income, net.   Interest and other income, net consists of the interest earned on our cash and investment accounts as well as gains/losses on our trading securities and the Right from UBS entitling us to sell at par value auction-rate securities previously purchased from UBS (approximately $26.3 million, par value) at anytime during a two-year period from June 30, 2010 through July 2, 2012.

Income Taxes.    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, 2009.

Results of Operations

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

 
 
Three Months Ended
   
Six Months Ended
 
 
 
June 30,
   
June 30,
 
 
 
2010
   
2009
   
2010
 
2009
 
Net revenues     100 %     100 %     100 %     100 %
Cost of revenues
    50 %     52 %     49 %     53 %
Gross profit
    50 %     48 %     51 %     47 %
Operating expenses:
                               
Technology and development
    27 %     28 %     27 %     29 %
Sales and marketing
    24 %     23 %     23 %     22 %
General and administrative
    21 %     21 %     20 %     20 %
Loss from operations
    (22 )%     (24 )%     (19 )%     (24 )%
Interest expense
    0 %     0 %     0 %     0 %
Interest and other income, net
    1 %     1 %     1 %     1 %
Loss before income taxes
    (21 )%     (23 )%     (18 )%     (23 )%
Benefit from income taxes
    8 %     9 %     7 %     9 %
 
                               
Net loss
    (13 )%     (14 )%     (11 )%     (14 )%
 
 
Comparison of the Three Month Periods Ended June 30, 2010 and 2009
 
 
Three Months Ended June 30,
 
 
2010
 
2009
 
$ Change
   
% Change
 
 
(in thousands)
 
Net revenues
  $ 46,807     $ 38,858     $ 7,949       20 %
Cost of net revenues
  $ 23,179     $ 20,069     $ 3,110       15 %
Gross profit
  $ 23,628     $ 18,789     $ 4,839       26 %
Percentage of net revenues
    50 %     48 %     -       -  

Net revenues increased $7.9 million, or 20%, for the three months ended June 30, 2010, as compared to the same period in 2009. Revenue growth was attributable to an increase in personalized products and services revenues offset by a decrease in print revenue. PPS revenues increased $8.1 million, or 34%, to $31.7 million for the three months ended June 30, 2010 as compared to the same period in 2009. The increase in PPS is primarily a result of increased sales of photo books and stationery cards.  PPS represented 68% of revenue compared to 61% in the same period in 2009.   Revenue from our commercial print initiative totaled $0.8 million, and represented 1% of our total net revenues.  Print revenue decreased $0.2 million, or 2%, to $14.4 million for the three months ended June 30, 2010, as compared to the same period in 2009. Print revenue represented 31% of revenue compared to 38% in the same period in 2009.  The decrease in overall print revenue is primarily due to lower average sales prices with various 4x6 print marketing campaigns.  In the second quarter of 2010, 4x6 print revenues represented 16% of total net revenues versus 22% in the second quarter of 2009.

Excluding commercial print revenues, net revenue increases were also the result of year-over-year increases in all of our key metrics: customers, orders and average order value, as noted below:

 
Three Months Ended June 30,
 
 
2010
 
2009
 
$ Change
   
% Change
 
 
(in thousands, except AOV amounts)
 
Customers
    1,118       946       172       18 %
Orders
    1,802       1,653       149       9 %
Average order value
  $ 25.56     $ 23.09     $ 2.47       11 %

Cost of net revenues increased $3.1 million, or 15%, for the three months ended June 30, 2010 as compared to the same period in 2009.  As a percentage of net revenues, cost of net revenues decreased from 52% to 50% for the same period in 2009, which increased gross margin from 48% in the second quarter of 2009 to 50% in the second quarter of 2010.  The increase in our gross margin percentage is primarily due to the favorable improvements from product mix as well as labor efficiencies and improvements in material costs, partially offset by promotional discounts and lower-margin commercial print revenues.  In addition, during the three months ended June 30, 2009, we incurred various transition costs associated with our Phoenix manufacturing facility that we did not incur in 2010.

 
 
Three Months Ended June 30,
 
 
 
2010
   
2009
   
$ Change
   
% Change
 
 
 
(in thousands)
 
Technology and development
  $ 12,477     $ 10,963     $ 1,514       14 %
Percentage of net revenues
    27 %     28 %     -       -  
Sales and marketing
  $ 11,311     $ 8,901     $ 2,410       27 %
Percentage of net revenues
    24 %     23 %     -       -  
General and administrative
  $ 9,620     $ 8,333     $ 1,287       15 %
Percentage of net revenues
    21 %     21 %     -       -  

Our technology and development expense increased $1.5 million, or 14%, for the three months ended June 30, 2010, as compared to the same period in 2009.  As a percentage of revenue, this expense decreased from 28% to 27% for the same period in 2009. The overall increase in technology and development expense was primarily attributable to an increase of $1.4 million related to personnel and related costs for employees and consultants involved with website development and website infrastructure support teams.  Professional and outside service fees also increased by $0.3 million and stock-based compensation increased by $0.2 million.  However, these factors were partially offset by a decrease in depreciation expense of $0.3 million. For the three months ended June 30, 2010 and 2009, we capitalized $1.3 million and $1.5 million, respectively, in eligible costs associated with software developed or obtained for internal use.

Our sales and marketing expense increased $2.4 million, or 27%, for the three months ended June 30, 2010, as compared to the same period in 2009.  As a percentage of net revenues, total sales and marketing expense increased slightly from 23% to 24% for the same period in 2009.  The increase in sales and marketing expense was primarily due to an increase of $1.8 million related to expanded online advertising, direct response, partner marketing campaigns, and search fees.  The increase is also attributable to a $0.3 million increase in personnel and related costs associated with the expansion of our internal marketing team and an increase of $0.2 million in stock based compensation.

 
Our general and administrative expense increased $1.3 million, or 15%, for the three months ended June 30, 2010 as compared to the same period in 2009. As a percentage of revenue, this expense remained flat at 21%. The increase was attributable primarily to $0.8 million of stock based compensation costs, $0.4 million for personnel related costs, and $0.2 million of professional fees.   We also incurred a $0.2 million increase in credit card fees, associated with our increased revenue year over year.  The increase in general and administrative expenses was partially offset by a decrease in facility costs of $0.2 million and a gain on the disposal of certain fixed assets of $0.1 million.
 
 
 
Three Months Ended June 30,
 
 
 
2010
   
2009
   
Change
 
 
 
(in thousands)
 
Interest expense
  $ (21 )   $ (27 )   $ 6  
Interest and other income, net
  $ 194     $ 283     $ (89 )

Interest expense decreased slightly in the three months ended June 30, 2010, as compared to the three months ended June 30, 2009.  On June 23, 2010, the Company’s $20.0 million line of credit facility with Silicon Valley Bank expired, and was not renewed.

Interest and other income, net decreased by $89,000 or 31% for the three months ended June 30, 2010, as compared to the same period in 2009.  The decrease was primarily due to an overall lower yield on our investment portfolio relative to our investment balances in the comparable prior year period.  During the three months ended June 30, 2010, we recorded a $3.3 million mark-to-market gain on our auction-rate securities that have been classified as trading securities, which was entirely offset by a $3.3 million loss on the UBS Right.
 
 
Three Months Ended
June 30,
 
 
2010
 
2009
 
 
(in thousands)
 
Income tax benefit
  $ 3,722     $ 3,497  
Effective tax rate
    39 %     38 %

The benefit for income taxes was $3.7 million for the three months ended June 30, 2010, compared to the benefit of $3.5 million for the same period in 2009. The increase in our effective tax rate was primarily the result of the exclusion of federal research and development credits in the three months ended June 30, 2010, compared to same period in the prior year.  The United States Congress has not extended the tax credits for research and development activities as of June 30, 2010 and therefore, we have not included this credit in our tax rate.

As of June 30, 2010, we had approximately $32.7 million of state net operating loss carryforwards available to reduce future taxable income. These net operating loss carryforwards begin to expire in 2014 for state tax purposes.
 
    Three Months Ended June 30,  
      2010       2009       % Change  
      (in thousands)  
Loss before income taxes
    $ (9,607 )   $ (9,152 )     5 %
Net loss
    $ (5,885 )   $ (5,655 )     4 %

Net loss increased by $0.2 million for the three months ended June 30, 2010 as compared to the same period in 2009. As a percentage of net revenue, net loss was 13% and 14% for the three months ended June 30, 2010 and June 30, 2009, respectively.

Comparison of the Six Month Period Ended June 30, 2010 and 2009

 
Six Months Ended June 30,
 
 
2010
 
2009
 
$ Change
 
% Change
 
 
(in thousands)
 
Net revenues
  $ 92,549     $ 74,870     $ 17,679     24 %
Cost of net revenues
  $ 45,757     $ 39,741     $ 6,016     15 %
Gross profit
  $ 46,792     $ 35,129     $ 11,663     33 %
Percentage of net revenues
    51 %     47 %     -      -  

Net revenues increased $17.7 million, or 24% for the six months ended June 30, 2010 as compared to the same period in 2009. Revenue growth was attributable to the increase in personalized products and services revenues and revenues from our commercial print initiative, offset by a decrease in print revenue. PPS increased $17.3 million, or 39%, to $62.2 million for the six months ended June 30, 2010 as compared to the same period in 2009. The increase in PPS is primarily a result of increased sales of photo books and stationery cards.  PPS made up 67% of net revenues for the six months ended June 30, 2010, up from 60% for the same period in 2009.   Revenue from our commercial print initiative totaled $2.3 million, and represented 3% of our total net revenues.  Print revenue decreased $0.5 million, or 2%, to $28.1 million for the six months ended June 30, 2010 as compared to the same period in 2009.  The decrease in overall print revenue is primarily due to lower average sales prices with various 4x6 print marketing campaigns.

 
Cost of net revenues increased $6.0 million, or 15%, for the six months ended June 30, 2010 as compared to the same period in 2009.  As a percentage of net revenues, cost of net revenues decreased from 53% to 49% for the same period in 2009, which increased gross margin from 47% to 51% for the six months ended June 30, 2009 and 2010, respectively.    The increase in our gross margin percentage is primarily due to the favorable improvements from product mix as well as labor efficiencies and improvements in material costs; partially offset by promotional discounts and lower-margin commercial print revenues.  In addition, during the six months ended June 30, 2009, we incurred various transition costs associated with our Phoenix manufacturing facility that we did not incur in 2010.

 
 
Six Months Ended June 30,
 
 
 
2010
   
2009
   
$ Change
 
% Change
 
 
 
(in thousands)
 
Technology and development
  $ 24,646     $ 21,957     $ 2,689     12 %
Percentage of net revenues
    27 %     29 %      -      -  
Sales and marketing
  $ 21,468     $ 16,698     $ 4,770     29 %
Percentage of net revenues
    23 %     22 %      -      -  
General and administrative
  $ 18,421     $ 15,279     $ 3,142     21 %
Percentage of net revenues
    20 %     20 %      -      -  

Our technology and development expense increased $2.7 million, or 12%, for the six months ended June 30, 2010 as compared to the same period in 2009.  As a percentage of revenue, technology and development expense for the six months ended June 30, 2010 decreased from 29% to 27% for the same period in 2009. The overall increase in technology and development expense was primarily attributable to an increase of $2.3 million related to personnel and related costs for employees and consultants involved with website development and website infrastructure support teams.  Professional and outside service fees also increased by $0.6 million and stock-based compensation increased by $0.3 million.  However, these factors were partially offset by decreases in depreciation expense of $0.5 million and facility costs of $0.1 million. For the six months ended June 30, 2010 and 2009, we capitalized $2.2 million and $2.8 million, respectively, in eligible costs associated with software developed or obtained for internal use.

Our sales and marketing expense increased $4.8 million, or 29%, for the six months ended June 30, 2010 as compared to the same period in 2009.  This expense increased as a percentage of net revenues from 22% to 23% for the same period in 2009. The increase in sales and marketing expense was primarily due to an increase of $3.2 million related to expanded online advertising, direct response, partner marketing campaigns, and search fees.  The increase is also attributable to a $0.9 million increase in personnel and related costs associated with the expansion of our internal marketing team and an increase of $0.6 million in stock based compensation.

Our general and administrative expense increased $3.1 million, or 21%, for the six months ended June 30, 2010 as compared to the same period in 2009. As a percentage of revenue, this expense remained flat at 20%. The increase in general and administrative expense is primarily due to increases in stock-based compensation of $1.8 million, consulting and other professional service costs of $1.0 million, and personnel and related costs for employees of $0.6 million.  We also incurred a $0.5 million increase in credit card fees, associated with our increased revenue year over year.  These increases were partially offset by the final installment payment from a cross-licensing agreement which was received in the first quarter 2010, a decrease in facility costs of $0.2 million and a gain on the disposal of certain fixed assets of $0.1 million.

 
 
Six Months Ended June 30,
 
 
 
2010
   
2009
   
Change
 
 
 
(in thousands)
 
Interest expense
  $ (42 )   $ (114 )   $ 72  
Interest and other income, net
  $ 436     $ 607     $ (171 )

Interest expense decreased by $72,000 or 63% for the six months ended June 30, 2010, as compared to the same period in 2009, due to higher amortization of origination costs associated with our previous line of credit with JP Morgan that expired in April 2009 and was replaced by a $20.0 million line of credit with Silicon Valley Bank on June 23, 2009. On June 23, 2010, the line of credit facility with Silicon Valley Bank expired, and was not renewed.

Interest and other income, net decreased by $171,000 or 28% for the six months ended June 30, 2010, as compared to the same period in 2009.  This decrease is primarily due to an overall lower yield on our investment portfolio relative to our investment balances in the comparable prior year periods.  During the six months ended June 30, 2010, we recorded a $3.0 million mark-to-market gain on our auction-rate securities that have been classified as trading securities which was entirely offset by a $3.0 million loss on the UBS Right.
 
 
Six Months Ended June 30,
 
2010
2009
 
(in thousands)
Income tax benefit
  $ 6,733     $ 6,426  
Effective tax rate
    39 %     35 %

The benefit for income taxes was $6.7 million for the six months ended June 30, 2010, compared to benefits of $6.4 million for the same period in 2009.  The increase in our effective tax rate was primarily the result of the exclusion of federal research and development credits in the six months ended June 30, 2010, compared to same period in the prior year.  The United States Congress has not extended the tax credits for research and development activities as of June 30, 2010 and therefore, we have not included this credit in our tax rate.

 
 
Six Months Ended June 30,
 
2010
2009
% Change
 
(in thousands)
Loss before income taxes
  $ (17,349 )   $ (18,312 )     (5 ) %
Net loss
  $ (10,616 )   $ (11,886 )     (11 ) %

Net loss decreased by $1.3 million, or 11%, for the six months ended June 30, 2010 as compared to the same period in 2009.

Liquidity and Capital Resources
 
 
Six Months Ended June 30,
 
 
2010
 
2009
 
 
(in thousands)
 
Consolidated Statements of Cash Flows Data:
 
 
 
 
Purchases of property and equipment
  $ 8,630     $ 6,102  
Capitalization of software and website development costs
    2,049       1,938  
Depreciation and amortization
    13,969       13,485  
Cash flows used in operating activities
    (23,163 )     (16,411 )
Cash flows provided by (used in) investing activities
    10,973       (7,990 )
Cash flows provided by (used in) financing activities
    11,980       (184 )

We anticipate that our current cash and cash equivalents balances and cash generated from operations will be sufficient to meet our working capital requirements, capital 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 sell additional debt or equity. 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.

At June 30, 2010, we held approximately $26.3 million par value of variable rate bond investments with a fair value of approximately $23.1 million, classified as short-term investments, with an auction reset feature (“auction rate securities” or "ARS") whose underlying assets are student loans which are substantially backed by the federal government.  Since February 2008, these auctions have failed.  In November 2008, we accepted an offer (the “Right”) from UBS AG (“UBS”), one of our investment providers, entitling us to sell at par value ARS purchased from UBS at anytime during a two-year period from June 30, 2010 through July 2, 2012.  During the three and six months ended June 30, 2010 we liquidated ARS investments (at par value) of $21.2 million and $21.6 million, respectively, which were called by the state issuers.  The proceeds were subsequently invested in Treasury securities.

At June 30, 2010, we had $159.0 million of cash, cash equivalents and short-term investments. Also, on June 30, 2010, we exercised the UBS Right to liquidate all of the remaining ARS investments at par value. On July 1, 2010, that transaction was executed and we received proceeds of $26.3 million, which were immediately invested in Treasury securities. With increased liquidity resulting from the ARS redemption, we elected not to renew the $20.0 million line of credit facility with Silicon Valley Bank that expired on June 23, 2010.

We anticipate that total 2010 capital expenditures will range between 7% to 9% of annual net revenues.  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. Our expenditures also include costs associated with capitalized software and website development.  This range of capital expenditures is not outside the ordinary course of our business or materially different from how we have expanded our business in the past. We believe that such capital expenditures will have a positive effect on our results of operations if demand increases in line with increases in our production capacity. However, these capital expenditures will have a negative effect on our results of operations if demand does not increase as we expect, and will have a negative effect on our results of operations in the short term if demand does not increase simultaneously, as we expect, with the capital expenditures spent to support increased demand.

Operating Activities. For the six months ended June 30, 2010, net cash used in operating activities was $23.2 million, primarily due to our net loss of $10.6 million and the net change in operating assets and liabilities of $31.2 million.  Net cash used in operating activities was adjusted for non-cash items including $12.7 million of depreciation and amortization expense, $3.3 million benefit from deferred income taxes and $8.4 million of stock-based compensation. Another non-cash item included in operating activities is $1.3 million of amortization of intangible assets which includes $0.3 million of amortization of prepaid royalties associated with intellectual property licenses that were entered into during 2009.

For the six months ended June 30, 2009, net cash used in operating activities was $16.4 million, primarily due to our net loss of $11.9 million and the net change in operating assets and liabilities of $23.3 million, adjusted for non-cash items including $13.5 million of depreciation and amortization expense, $0.3 million benefit from deferred income taxes and $5.6 million of stock-based compensation, net of $0.8 million of capitalized stock based compensation related to website development activity.

 
Investing Activities. For the six months ended June 30, 2010, net cash provided by investing activities was $11.0 million.  We used $8.6 million for capital expenditures for computer and network hardware to support our website infrastructure and information technology systems, capital expenditures for production equipment for our manufacturing and production operations, and $2.0 million of capitalized software and website development.  The use of cash was offset by cash provided from the liquidation of $21.6 million (at par value) of our ARS investments that were called by various issuers at par.

For the six months ended June 30, 2009, net cash used in investing activities was $8.0 million.  We used $6.1 million for capital expenditures for computer and network hardware to support our website infrastructure and information technology systems, capital expenditures for production equipment for our manufacturing and production operations, and $2.0 million of capitalized software and website development.

Financing Activities. For the six months ended June 30, 2010, net cash provided by financing activities was $12.0 million, primarily from $7.9 million of proceeds from issuance of common stock from the exercise of options and $4.1 million from excess tax benefits from stock-based compensation.

Our financing activities for the six months ended June 30, 2009 used $0.2 million of cash, primarily for payments of capitalize lease obligations and for employee withholding tax liability for restricted shares vested offset by proceeds from issuance of common stock.

Non-GAAP Financial Measures

Regulation G, conditions for use of Non-Generally Accepted Accounting Principles ("Non-GAAP") financial measures, and other SEC regulations define and prescribe the conditions for use of certain Non-GAAP financial information. We closely monitor two financial measures, adjusted EBITDA and free cash flow which meet the definition of Non-GAAP financial measures. We define adjusted EBITDA as earnings before interest, taxes, depreciation, amortization and stock-based compensation.  Free cash flow is defined as adjusted EBITDA less purchases of property and equipment and capitalization of software and website development costs.  Management believes these Non-GAAP financial measures reflect an additional way of viewing our profitability and liquidity that, when viewed with our GAAP results, provides a more complete understanding of factors and trends affecting our earnings and cash flows.  Refer below for a reconciliation of both adjusted EBITDA and free cash flow to the most comparable GAAP measure.

To supplement our consolidated financial statements presented on a GAAP basis, we believe that these Non-GAAP measures provide useful information about our core operating results and thus are appropriate to enhance the overall understanding of our past financial performance and our prospects for the future. These adjustments to our GAAP results are made with the intent of providing both management and investors a more complete understanding of our underlying operational results and trends and performance. Management uses these Non-GAAP measures to evaluate our financial results, develop budgets, manage expenditures, and determine employee compensation. The presentation of additional information is not meant to be considered in isolation or as a substitute for or superior to net income (loss) or net income (loss) per share determined in accordance with GAAP. Management strongly encourages shareholders to review our financial statements and publicly-filed reports in their entirety and not to rely on any single financial measure.

The table below shows the trend of adjusted EBITDA and free cash flow as a percentage of net revenues for the three and six months ended June 30, 2010 and 2009 (in thousands):
 
 
Three Months Ended
 
Six Months Ended
 
 
June 30,
 
June 30,
 
 
2010
 
2009
 
2010
 
2009
 
 
   
Net revenues
  $ 46,807     $ 38,858     $ 92,549     $ 74,870  
                                 
 Non-GAAP Adjusted EBITDA
  $ 1,228     $ 205     $ 4,659     $ 318  
EBITDA % of Net revenues
    3 %     1 %     5 %     0 %
 
                               
Free cash flow
  $ (4,029 )   $ (2,735 )   $ (6,934 )   $ (7,604 )
Free cash flow % of Net revenues
    (9 )%     (7 )%     (7 )%     (10 )%

By carefully managing our operating costs and capital expenditures, we were able to make the strategic investments we believe are necessary to grow and strengthen our business, while at the same time increasing our adjusted EBITDA profitability and improving our free cash flows.  For the three and six months ended June 30, 2010, our adjusted EBITDA profitability was $1.2 million and $4.7 million, respectively, as compared to $0.2 million and $0.3 million in the same periods in 2009.  These adjusted EBITDA improvements resulted from a consistent, sustained effort to manage our cost structure in line with our revenue growth and reflects our commitment of balancing investments in growth with delivering increasing profitability.  During the three and six months ended June 30, 2010, we experienced negative free cash flows of $4.0 million and $6.9 million, respectively. This trend is consistent with the seasonality of our business as we make investments in technology and marketing infrastructure in the first three quarters of the year, to support the increased activity in the fourth quarter.  In addition, on an annual basis, our capital expenditures have decreased each year from 2007 to 2009, as we continue to make strategic capital investments to support our overall growth as a business, improve efficiencies in our production and satisfy our customer needs while improving our cost imperatives. We anticipate that total 2010 capital expenditures will range between 7% to 9% of 2010 net revenues.

 
Free cash flow has limitations due to the fact that it does not represent the residual cash flow for discretionary expenditures.  For example, free cash flow does not incorporate payments made on capital lease obligations or cash requirements to comply with debt covenants.  Therefore, we believe that it is important to view free cash flow as a complement to our reported consolidated financial statements.

The following is a reconciliation of adjusted EBITDA and free cash flow to the most comparable GAAP measure, for the three and six months ended June 30, 2010 and 2009 (in thousands):
 
 Reconciliation of Net Loss to Non-GAAP Adjusted EBITDA
 
Three Months Ended
   
Six Months Ended
 
 
 
June 30,
   
June 30,
 
 
 
2010
   
2009
   
2010
   
2009
 
 
     
Net loss
  $ (5,885 )   $ (5,655 )   $ (10,616 )   $ (11,886 )
Add back:
                               
Interest expense
    21       27       42       114  
Interest and other income, net
    (194 )     (283 )     (436 )     (607 )
Tax benefit (provision)
    (3,722 )     (3,497 )     (6,733 )     (6,426 )
Depreciation and amortization
    6,949       6,779       13,969       13,485  
Stock-based compensation expense
    4,059       2,834       8,433       5,638  
Non-GAAP Adjusted EBITDA
  $ 1,228     $ 205     $ 4,659     $ 318  
                                 
Reconciliation of Cash Flow from Operating Activities to Non-GAAP Adjusted EBITDA and Free Cash Flow
 
Three Months Ended
   
Six Months Ended
 
 
 
June 30,
   
June 30,
 
 
    2010       2009       2010       2009  
 
     
Net cash used in operating activities
  $ 5,101     $ 2,847     $ (23,163 )   $ (16,411 )
Add back:
                               
Interest expense
    21       27       42       114  
Interest and other income, net
    (194 )     (283 )     (436 )     (607 )
Tax benefit (provision)
    (3,722 )     (3,497 )     (6,733 )     (6,426 )
Changes in operating assets and liabilities
    (1,969 )     (1,236 )     31,184       23,275  
Other adjustments
    1,991       2,347       3,765       373  
Non-GAAP Adjusted EBITDA
    1,228       205       4,659       318  
Less:
                               
Purchases of property and equipment, including accrued amounts
    (4,010 )     (1,826 )     (9,544 )     (5,984 )
Capitalized technology & development costs
    (1,247 )     (1,114 )     (2,049 )     (1,938 )
Free cash flow
  $ (4,029 )   $ (2,735 )     (6,934 )     (7,604 )

 
Off-Balance Sheet Arrangements

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

Recent Accounting Pronouncements

Effective January 1, 2010, we adopted revised guidance intended to improve disclosures related to fair value measurements, issued by the Financial Accounting Standards Board ("FASB"). This guidance requires us to separate information about significant transfers in and out of Level 1 and Level 2 and the reason for such transfers, and also requires information related to purchases, sales, issuances, and settlements information of Level 3 financial assets to be included in the rollforward of activity. The guidance also requires us to provide certain disaggregated information on the fair value of financial assets and requires us to disclose valuation techniques and inputs used for both recurring and nonrecurring fair value measurements of our Level 2 and Level 3 financial assets. We have provided the additional required disclosures effective January 1, 2010.

 
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

Interest Rate and Credit Risk.   We have exposure to interest rate risk that relates primarily to our investment portfolio. All of our cash equivalents are carried at market value. We do not currently use or plan to use derivative financial instruments in our investment portfolio. The risk associated with fluctuating interest rates is limited to our investment portfolio and we do not believe that a 10% change in interest rates will have a significant impact on our interest income, operating results or liquidity.

During the three and six months ended June 30, 2010 we liquidated ARS investments (at par value) of $21.2 million and $21.6 million, respectively, which were called by the state issuers.  The proceeds were subsequently invested in Treasury securities.  On June 30, 2010, we exercised the UBS Right to liquidate our remaining ARS investments at par value.  On July 1, 2010, that transaction was executed, and we received proceeds of $26.3 million, which were immediately invested in Treasury securities.  As a result of this liquidation, we are no longer subject to the unique market risk associated with these investments and the Right.

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

ITEM 4. CONTROLS AND PROCEDURES

Our management, with the participation of our chief executive officer and chief financial officer, evaluated the effectiveness of our disclosure controls and procedures as of June 30, 2010. The term “disclosure controls and procedures,” as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act, means controls and other procedures of a company that are designed to ensure that information required to be disclosed by a company in the reports that it files or submits under the Exchange Act is recorded, processed, summarized and reported, within the time periods specified in the SEC’s rules and forms. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed by a company in the reports that it files or submits under the Exchange Act is accumulated and communicated to the company’s management, including its principal executive and principal financial officers, as appropriate to allow timely decisions regarding required disclosure. Management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving their objectives and management necessarily applies its judgment in evaluating the cost-benefit relationship of possible controls and procedures. Based on the evaluation of our disclosure controls and procedures as of June 30, 2010, our chief executive officer and chief financial officer concluded that, as of such date, the Company’s disclosure controls and procedures were effective at the reasonable assurance level.

No change in our internal control over financial reporting (as defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) occurred during the quarter ended June 30, 2010 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

 
PART II — OTHER INFORMATION

ITEM 1. LEGAL PROCEEDINGS

From time to time, we may be involved in various legal proceedings arising in the ordinary course of business.  In all cases, at each reporting period, we evaluate 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, we accrue for the amount, or if a range, we accrue the low end of the range as a component of legal expense.
 
ITEM 1A. RISK FACTORS

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

Our business is highly seasonal, with a high proportion of our net revenues, net income and operating cash flows generated during the fourth quarter. For example, we generated more than 50% of our 2009 net revenues in the fourth quarter of 2009, and the net income that we generated during the fourth quarter of 2009 was necessary for us to achieve profitability on an annual basis. In addition, we incur significant additional expenses in the period leading up to the fourth quarter holiday season including expenses related to the hiring and training of temporary workers to meet our seasonal needs, additional inventory and equipment purchases and increased advertising. If we are unable to accurately forecast and respond to consumer demand for our products during the fourth quarter, our financial results, reputation and brand will suffer and the market price of our common stock would likely decline.

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

In addition, our operations and financial performance depend on general economic conditions.  The U.S. economy is experiencing a slow economic recovery from a deep recession, concerns about inflation, low consumer confidence, high unemployment rate and other adverse business conditions.  Fluctuations in the U.S. economy such as the recent recession could cause, among others, prolonged decline in consumer spending and increase in the cost of labor and materials.  These conditions could exacerbate variability in our forecasting and could negatively affect our results of operations.

Our limited operating history makes it difficult to assess the exact impact of the seasonal factors on our business or the extent to which our business is susceptible to cyclical fluctuations in the U.S. economy. In addition, our historically rapid growth may have overshadowed whatever seasonal or cyclical factors might have influenced our business to date. Seasonal or cyclical variations in our business may become more pronounced over time and may harm our future operating results.

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

We believe that we must continue to grow our current production capability to meet our projected net revenue targets. We anticipate that total 2010 capital expenditures will range between 7% to 9% of 2010 net revenues.  Operational difficulties, such as a significant interruption in the operations of either our Charlotte, North Carolina or Phoenix, Arizona manufacturing facilities could delay production or shipment of our products.  Our inability to meet our production requirements could lead to customer dissatisfaction and damage our reputation and brand, which would result in reduced net revenues. Moreover, if the costs of meeting production requirements, including capital expenditures, were to exceed our expectations, our results of operations would be harmed.

In addition, we face significant production risks at peak holiday seasons, including the risks of obtaining sufficient qualified seasonal production personnel. A majority of our workforce during the fourth quarter of 2009 was seasonal, temporary personnel. We have had difficulties in the past finding a sufficient number of qualified seasonal employees, and our failure to obtain qualified seasonal production personnel at any of our production facilities could harm our operations.

Economic trends could adversely affect our financial performance.

We are subject to macro-economic fluctuations in the U.S. economy.  Macro-economic issues involving the broader financial markets, including the housing and credit system, have negatively impacted the economy and our financial performance.

Weak economic conditions and low consumer spending and consumption may harm our operating results.  Purchases of our products are often discretionary. If the economic climate does not improve, customers or potential customers could delay, reduce or forego their purchases of our products and services, which could impact our business in a number of ways, including lower prices for our products and services and reduced sales.  In addition, the current economic conditions may lead to price increases by our suppliers or increase our operating expenses due to, among others, higher costs of labor, energy, equipment and facilities.  A prolonged and slow economic recovery may also lead to additional restructuring actions and associated expenses.  For example, during the first quarter of 2009, we reduced our headcount by 5%.  Due to reduced consumer spending and increased competitive pressures in the current economic environment, we may not be able to pass these increased costs on to our customers.  The resulting increased expenses and/or reduced income would negatively impact our operating results.

If the economic recovery is slow, or if the economy enters a prolonged period of decelerating growth, our results of operations may be further harmed.
 
 
Our quarterly financial results may fluctuate, which may lead to volatility in our stock price.
 
Our future revenues and operating results may vary significantly from quarter-to-quarter due to a number of factors, many of which are difficult for us to predict and control. Factors that could cause our quarterly operating results to fluctuate include:
 
 
general economic conditions, including recession and slow economic growth in the U.S. and worldwide and higher inflation, as well as those economic conditions specific to the Internet and e-commerce industries;

 
demand for our products and services, including seasonal demand;

 
our pricing and marketing strategies and those of our competitors;

 
our ability to attract visitors to our website and convert those visitors into customers;

 
our ability to retain customers and encourage repeat purchases;

 
our ability to sustain our profit margins, and our ability to diversify our product offerings, promote our new products and services and sell to consumers photo-based products such as photo books, calendars and cards;

 
the costs of customer acquisition;

 
our ability to manage our production and fulfillment operations;

 
the costs to produce our prints and photo-based products and merchandise and to provide our services;

 
the costs of expanding or enhancing our technology or website;

 
a significant increase in returns and credits, beyond our estimated allowances, for customers who are not satisfied with our products;

 
declines or disruptions to the travel industry;

 
variations in weather, particularly heavy rain and snow which tend to depress travel and picture taking;
 
 
 
the timing of holidays;

 
volatility in our stock price, which may lead to higher stock-based compensation expense;

 
consumer preferences for digital photography services;

 
improvements to the quality, cost and convenience of desktop printing of digital pictures and products; and

 
global and geopolitical events with indirect economic effects such as pandemic disease, war, threat of war or terrorist actions.

 
Based on the factors cited above, we believe that quarter-to-quarter comparisons of our operating results are not a good indication of our future performance. It is possible that in one or more future quarters, our operating results may be below the expectations of public market analysts and investors. In that event, the trading price of our common stock may decline.

We have incurred operating losses in the past and may not be able to sustain profitability in the future.

We have periodically experienced operating losses since our inception in 1999. In particular, we make investments in our business that generally result in operating losses in each of the first three quarters of our fiscal year. This typically has enabled us to generate the majority of our net revenue during the fourth quarter and to achieve profitability for the full fiscal year. If we are unable to produce our products and provide our services at commercially reasonable costs, if customer demand and revenues decline or if our expenses exceed our expectations, we may not be able to achieve, sustain or increase profitability on a quarterly or annual basis.

We face many risks, uncertainties, expenses and difficulties relating to increasing our market share and growing our business.

To address the risks and uncertainties of increasing our market share and growing our business, we must do the following:

 
maintain and increase the size of our customer base;

 
maintain and enhance our brand;

 
enhance and expand our products and services;

 
 
maintain and grow our website and customer operations;

 
successfully execute our business and marketing strategy;
 
 
 
continue to develop and upgrade our technology and information processing systems;

 
continue to enhance our service to meet the needs of a changing market;

 
provide superior customer service;

 
respond to competitive developments; and

 
attract, integrate, retain and motivate qualified personnel.

We may be unable to accomplish one or more of these requirements, which could cause our business to suffer. Accomplishing one or more of these requirements might be very expensive, which could harm our financial results.

If we are not able to reliably meet our data storage and management requirements, customer satisfaction and our reputation could be harmed.

As a part of our current business model, we offer our customers free unlimited online storage and sharing of photographs and, as a result, must store and manage many petabytes of data. This policy results in immense system requirements and substantial ongoing technological challenges, both of which are expected to continue to increase over time. If we are not able to reliably meet these data storage and management requirements, we could have disruptions in services which could impair customer satisfaction and our reputation and lead to reduced net revenues and increased expenses. Moreover, if the cost of meeting these data storage and management requirements exceeds our expectations, our results of operations would be harmed.

Our data storage system could suffer damage or interruption from human error, fire, flood, power loss, telecommunications failure, break-ins, terrorist attacks, acts of war and similar events. In addition, our primary storage facilities are located near a major fault line, increasing our susceptibility to the risk that an earthquake could significantly harm our data storage system. If we experience disruption to our redundant systems located at our data storage center, such disruption could result in the deletion or corruption of customer stored images.

Interruptions to our website, information technology systems, print production processes or customer service operations could damage our reputation and brand and substantially harm our business and results of operations.

The satisfactory performance, reliability and availability of our website, information technology systems, printing production processes and customer service operations are critical to our reputation, and our ability to attract and retain customers and maintain adequate customer satisfaction. Any interruptions that result in the unavailability of our website or reduced order fulfillment performance or customer service could result in negative publicity, damage our reputation and brand and cause our business and results of operations to suffer. For example, in the second quarter of 2008, we experienced website performance issues in conjunction with a large release of additional website functionality which impacted our key metrics and revenue. This risk is heightened in the fourth quarter, as we experience significantly increased traffic to our website during the holiday season. Any interruption that occurs during such time would have a disproportionately negative impact than if it occurred during a different quarter.

We depend in part on third parties to implement and maintain certain aspects of our communications and printing systems. Therefore many of the causes of system interruptions or interruptions in the production process may be outside of our control. As a result, we may not be able to remedy such interruptions in a timely manner, or at all. Our business interruption insurance policies do not address all potential causes of business interruptions that we may experience, and any proceeds we may receive from these policies in the event of a business interruption may not fully compensate us for the revenues we may lose.

We may have difficulty managing our growth and expanding our operations successfully.

We have website operations, offices and customer support centers in Redwood City, California, and production facilities in Charlotte, North Carolina and Phoenix, Arizona.  Our growth has placed, and will continue to place, a strain on our administrative and operational infrastructure. Our ability to manage our operations and growth will require us to continue to refine our operational, financial and management controls, human resource policies and reporting systems.

If we are unable to manage future expansion, we may not be able to implement improvements to our controls, policies and systems in an efficient or timely manner and may discover deficiencies in existing systems and controls. Our ability to provide a high-quality customer experience could be compromised, which would damage our reputation and brand and substantially harm our business and results of operations.

 
Competitive pricing pressures, particularly with respect to pricing and shipping, may harm our business and results of operations.
 
Demand for our products and services is sensitive to price, especially in times of slow economic growth and consumer conservatism. Many external factors, including our production and personnel costs, consumer sentiment and our competitors’ pricing and marketing strategies, can significantly impact our pricing strategies. If we fail to meet our customers’ price expectations, we could lose customers, which would harm our business and results of operations.

Changes in our pricing strategies have had, and may continue to have, a significant impact on our net revenues and net income. From time to time, we have made changes to our pricing structure, specifically for 4x6 prints, in order to remain competitive.  Like 4x6 prints, most of our other products are also offered by our competitors.  If in the future, due to competitor activities or other marketing strategies, we significantly reduce our prices on our products without a corresponding increase in volume, it would negatively impact our net revenues and could adversely affect our gross margins and overall profitability.

We generate a significant portion of our net revenues from the fees we collect from shipping our products. For example, these fees represented approximately 14%, 17% and 19% of our net revenues in 2009, 2008 and 2007 respectively.   We offer discounted or free shipping, with a minimum purchase requirement, during promotional periods to attract and retain customers. If free shipping offers extend beyond a limited number of occasions, are not based upon a minimum purchase requirement or become commonplace, our net revenues and results of operations would be negatively impacted. In addition, we occasionally offer free or discounted products and services to attract and retain customers. In the future, if we increase these offers to respond to actions taken by our competitors, our results of operations may be harmed.

We face intense competition from a range of competitors and may be unsuccessful in competing against current and future competitors.

The digital photography products and services industries are intensely competitive, and we expect competition to increase in the future as current competitors improve their offerings and as new participants enter the market or as industry consolidation further develops. Competition may result in pricing pressures, reduced profit margins or loss of market share, any of which could substantially harm our business and results of operations. We face intense competition from a wide range of companies, including the following:

 
Online digital photography services companies such as Kodak EasyShare Gallery (formerly known as Ofoto), Snapfish, which is a service of Hewlett-Packard, American Greetings’ Photoworks and Webshots brands, Vista Print, and others;

 
“Big Box” retailers such as Wal-Mart, Costco and others that are seeking to offer low cost digital photography products and services, such as in-store fulfillment and self-service kiosks for printing; these competitors may, among other strategies, offer their customers heavily discounted in-store products and services that compete directly with our offerings;

 
Drug stores such as Walgreens, CVS and others that offer in-store pick-up from Internet orders;

 
Regional photography companies such as Ritz Camera that have established brands and customer bases in existing photography markets;
 
 
 
Internet portals and search engines such as Yahoo!, AOL, and Google that offer broad-reaching digital photography and related products and services to their large user bases;

 
Home printing service providers such as Hewlett-Packard, Epson, Canon, and Kodak that are seeking to expand their printer and ink businesses by gaining market share in the emerging digital photography marketplace;

 
Photo-related software companies such as Apple, Microsoft and Corel;

 
Social media companies that host images such as MySpace, Facebook and Hi5;

 
Specialized companies in the photo book and stationery business such as Hallmark, American Greetings, Tiny Prints, Minted, Picaboo and Blurb; and

 
Self-publishing companies and services such as Lulu, CafePress and Amazon's CreateSpace.

Many of our competitors have significantly longer operating histories, larger and broader customer bases, greater brand and name recognition and greater financial, research and development and distribution resources, and operate in more geographic areas than we do. Well-funded competitors may be better able to withstand economic downturns and associated periods of reduced customer spending and increased pricing pressures.  The numerous choices for digital photography services can cause confusion for consumers, and may cause them to select a competitor with greater name recognition. Some competitors are able to devote substantially more resources to website and systems development or to investments or partnerships with traditional and online competitors. Well-funded competitors, particularly new entrants, may choose to prioritize growing their market share and brand awareness instead of profitability. Competitors and new entrants in the digital photography products and services industries may develop new products, technologies or capabilities that could render obsolete or less competitive many of our products, services and content. We may be unable to compete successfully against current and future competitors, and competitive pressures could harm our business and prospects.

 
If we are unable to adequately control the costs associated with operating our business, our results of operations will suffer.
 
The primary costs in operating our business are related to producing and shipping products, acquiring customers, compensating our personnel, acquiring equipment and technology and leasing facilities. If we are unable to keep these costs aligned with the level of revenues that we generate, our results of operations would be harmed. Controlling our business costs is challenging because many of the factors that impact these costs are beyond our control. For example, the costs to produce prints, such as the costs of photographic print paper, could increase due to a shortage of silver or an increase in worldwide energy prices.  In addition, we may become subject to increased costs by the third-party shippers that deliver our products to our customers, and we may be unable to pass along any increases in shipping costs to our customers. The costs of online advertising and keyword search could also increase significantly due to increased competition, which would increase our customer acquisition costs.

The loss of key personnel and an inability to attract and retain additional personnel could affect our ability to successfully grow our business.

We are highly dependent upon the continued service and performance of our senior management team and key technical, marketing and production personnel.  The loss of these key employees, each of whom is “at will” and may terminate his or her employment relationship with us at any time, may significantly delay or prevent the achievement of our business objectives.

We believe that our future success will also depend in part on our continued ability to identify, hire, train and motivate qualified personnel. We face intense competition for qualified individuals from numerous technology, marketing, financial services, manufacturing and e-commerce companies. In addition, competition for qualified personnel is particularly intense in the San Francisco Bay Area, where our headquarters are located. We may be unable to attract and retain suitably qualified individuals who are capable of meeting our growing operational and managerial requirements, or we may be required to pay increased compensation in order to do so.  Our failure to attract and retain qualified personnel could impair our ability to implement our business plan.

In order to attract and retain key personnel, we have amended our 2006 Equity Incentive Plan to provide for automatic increases through 2013 of the number of shares issuable under it and we may need to grant inducement equity awards outside of the plan, which would dilute the ownership of our existing stockholders.

At the 2010 annual meeting, our stockholders approved an amendment to our 2006 Equity Incentive Plan (the “2006 Plan”) to renew its “evergreen” provision.  According to the amendment, the number of shares available for issuance under the 2006 Plan will automatically increase as follows: (i) on January 1, 2011 by 3.5% of the number of shares issued and outstanding under the 2006 Plan on December 31, 2010; (ii) on January 1, 2012 by 3.3% of the number of shares issued and outstanding under the 2006 Plan on December 31, 2011, and (iii) on January 1, 2013 by 3.1% of the number of shares issued and outstanding under the 2006 Plan on December 31, 2012.  In addition, in order to attract key personnel, the Board authorized 380,000, 135,100 and 200,000 additional inducement stock option grants and restricted stock awards to supplement our 2006 Plan, which were granted in 2007, 2008 and 2009, respectively.  Inducement stock options and awards are granted to certain employees upon hire and do not require shareholder approval.  In the future, attracting key personnel may require a level of option grants in excess of the amount available in our 2006 Plan. The increase of the shares available for issuance under the 2006 Plan and grants of awards from it, as well as further inducement equity awards outside of the 2006 Plan, will cause dilution to our stockholders.

If we are unable to attract customers in a cost-effective manner, or if we were to become subject to e-mail blacklisting, traffic to our website would be reduced and our business and results of operations would be harmed.

Our success depends on our ability to attract customers in a cost-effective manner. We rely on a variety of methods to bring visitors to our website and promote our products, including paying fees to third parties who drive new customers to our website, purchasing search results from online search engines, e-mail and direct mail. We pay providers of online services, search engines, directories and other website and e-commerce businesses to provide content, advertising banners and other links that direct customers to our website. We also use e-mail and direct mail to offer free products and services to attract customers, and we offer substantial pricing discounts to encourage repeat purchases. Our methods of attracting customers, including acquiring customer lists from third parties, can involve substantial costs, regardless of whether we acquire new customers. Even if we are successful in acquiring and retaining customers, the cost involved in these efforts impacts our results of operations. Customer lists are typically recorded as intangible assets and may be subject to impairment charges if the fair value of that list exceeds its carrying value.  These potential impairment charges could harm our results from operations.  If we are unable to enhance or maintain the methods we use to reach consumers, if the costs of attracting customers using these methods significantly increase, or if we are unable to develop new cost-effective means to obtain customers, our ability to attract new customers would be harmed, traffic to our website would be reduced and our business and results of operations would be harmed.

In addition, various private entities attempt to regulate the use of e-mail for commercial solicitation. These entities often advocate standards of conduct or practice that significantly exceed current legal requirements and classify certain e-mail solicitations that comply with current legal requirements as unsolicited bulk e-mails, or “spam.”  Some of these entities maintain blacklists of companies and individuals, and the websites, Internet service providers and Internet protocol addresses associated with those entities or individuals that do not adhere to what the blacklisting entity believes are appropriate standards of conduct or practices for commercial e-mail solicitations. If a company’s Internet protocol addresses are listed by a blacklisting entity, e-mails sent from those addresses may be blocked if they are sent to any Internet domain or Internet address that subscribes to the blacklisting entity’s service or purchases its blacklist. From time to time we are blacklisted, sometimes without our knowledge, which could impair our ability to market our products and services, communicate with our customers and otherwise operate our business.  In addition, we have noted that unauthorized “spammers” utilize our domain name to solicit spam, which increases the frequency and likelihood that we may be blacklisted.

 
We may not succeed in promoting, strengthening and continuing to establish the Shutterfly brand, which would prevent us from acquiring new customers and increasing revenues.

A component of our business strategy is the continued promotion and strengthening of the Shutterfly brand. Due to the competitive nature of the digital photography products and services markets, if we are unable to successfully promote the Shutterfly brand, we may fail to substantially increase our net revenues. Customer awareness and the perceived value of our brand will depend largely on the success of our marketing efforts and our ability to provide a consistent, high-quality customer experience. To promote our brand, we have incurred, and will continue to incur, substantial expense related to advertising and other marketing efforts.

Our ability to provide a high-quality customer experience also depends, in large part, on external factors over which we may have little or no control, including the reliability and performance of our suppliers and third-party Internet and communication infrastructure providers. For example, some of our products, such as select photo-based merchandise, are produced and shipped to customers by our third-party vendors, and we rely on these vendors to properly inspect and ship these products. In addition, we rely on third-party shippers, including the U.S. Postal Service and United Parcel Service, to deliver our products to customers. Strikes, furloughs, reduced operations or other service interruptions affecting these shippers could impair our ability to deliver merchandise on a timely basis. Our products are also subject to damage during delivery and handling by our third-party shippers. Our failure to provide customers with high-quality products in a timely manner for any reason could substantially harm our reputation and our efforts to develop Shutterfly as a trusted brand. The failure of our brand promotion activities could adversely affect our ability to attract new customers and maintain customer relationships, which would substantially harm our business and results of operations.

If we are unable to develop, market and sell new products and services that address additional market opportunities, our results of operations may suffer.  In addition, we may need to expand beyond our current customer demographic to grow our business.

Although historically we have focused our business on consumer markets for silver halide prints, such as 4x6 prints, and photo-based products, such as photo books, stationery cards and calendars, we continually evaluate the demand for new products and services and the need to address these trends. In addition, we believe we may need to address additional markets and expand our customer demographic in order to further grow our business. We may not successfully expand our existing services or create new products and services, address new market segments or develop a significantly broader customer base. Any failure to address additional market opportunities could result in loss of market share, which would harm our business, financial condition and results of operations.

We may undertake acquisitions to expand our business, which may pose risks to our business and dilute the ownership of our existing stockholders.

A key component of our business strategy includes strengthening our competitive position and refining the customer experience on our website through internal development. However, from time to time, we may selectively pursue acquisitions of businesses, such as our 2008 acquisition of Nexo and our 2009 acquisition of TinyPictures. Integrating any newly acquired businesses, technologies or services is likely to be expensive and time consuming. To finance any acquisition, it may be necessary for us to raise additional funds through public or private financings. Additional funds may not be available on terms that are favorable to us, and, in the case of equity financings, would result in dilution to our stockholders. Also, the value of our stock may be insufficient to attract acquisition candidates.  If we do complete any acquisitions, we may be unable to operate the acquired businesses profitably or otherwise implement our strategy successfully. If we are unable to integrate any newly acquired entities, technologies or services effectively, our business and results of operations will suffer. The time and expense associated with finding suitable and compatible businesses, technologies or services could also disrupt our ongoing business and divert our management’s attention. Future acquisitions by us could also result in large and immediate write-offs or assumptions of debt and contingent liabilities, any of which could substantially harm our business and results of operations.

If either facility where our computer and communications hardware is located fails or if any of our production facilities fails, our business and results of operations would be harmed.

Our ability to successfully receive and fulfill orders and to provide high-quality customer service depends in part on the efficient and uninterrupted operation of our computer and communications systems. Substantially all of the computer hardware necessary to operate our website is located at two third-party hosting facilities in Santa Clara, California, and our production facilities are located in Charlotte, North Carolina and Phoenix, Arizona. Our systems and operations could suffer damage or interruption from human error, fire, flood, power loss, insufficient power availability, telecommunications failure, break-ins, terrorist attacks, acts of war and similar events. In addition, Santa Clara is located near a major fault line increasing our susceptibility to the risk that an earthquake could significantly harm the operations of these facilities. We maintain business interruption insurance, however, this insurance may be insufficient to compensate us for losses that may occur, particularly from interruption due to an earthquake which is not covered under our current policy. We do not presently have redundant systems in multiple locations.  In addition, the impact of any of these disasters on our business may be exacerbated by the fact that we are still in the process of developing our formal disaster recovery plan and we do not have a final plan in place.

 
Capacity constraints and system failures could prevent access to our website, which could harm our reputation and negatively affect our net revenues.
 
Our business requires that we have adequate capacity in our computer systems to cope with the high volume of visits to our website. As our operations grow in size and scope, we continually need to improve and upgrade our computer systems and network infrastructure to ensure reliable access to our website, in order to offer customers enhanced and new products, services, capacity, features and functionality. The expansion of our systems and infrastructure may require us to commit substantial financial, operational and technical resources before the volume of our business increases, with no assurance that our net revenues will increase.

Our ability to provide high-quality products and service depends on the efficient and uninterrupted operation of our computer and communications systems. If our systems cannot be expanded in a timely manner to cope with increased website traffic, we could experience disruptions in service, slower response times, lower customer satisfaction, and delays in the introduction of new products and services. Any of these problems could harm our reputation and cause our net revenues to decline.

Our technology, infrastructure and processes may contain undetected errors or design faults that could result in decreased production, limited capacity or reduced demand.

Our technology, infrastructure and processes may contain undetected errors or design faults. These errors or design faults may cause our website to fail and result in loss of, or delay in, market acceptance of our products and services. If we experience a delay in a website release that results in customer dissatisfaction during the period required to correct errors and design faults, we would lose revenue. In the future, we may encounter scalability limitations, in current or future technology releases, or delays in the commercial release of any future version of our technology, infrastructure and processes that could seriously harm our business.

We currently depend on third party suppliers for our photographic print paper, printing machines and other supplies, which expose us to risks if these suppliers fail to perform under our agreements with them.

We have historically relied on an exclusive supply relationship with Fuji Photo Film U.S.A. to supply all of our photographic paper for silver halide print production, such as 4x6 prints. In March 2010, we renewed our supply agreement with Fuji which expires in March 2013.  If that agreement is not renewed before it expires in March 2013, or if Fuji fails to perform in accordance with the terms of our agreement and if we are unable to secure a paper supply from a different source in a timely manner, we would likely fail to meet customer expectations, which could result in negative publicity, damage our reputation and brand and harm our business and results of operations. We purchase other photo-based supplies from third parties on a purchase order basis, and, as a result, these parties could increase their prices, reallocate supply to others, including our competitors, or choose to terminate their relationship with us. In addition, we purchase or rent a majority of the machines used to produce certain of our photo-based products from Hewlett-Packard, which is one of our primary competitors in the area of online digital photography services. This competition may influence their willingness to provide us with additional products or services. If we were required to switch vendors of machines for photo-based products, we may incur delays and incremental costs, which could harm our operating results.

We currently outsource some of our customer service activities and our production of photo-based products to third parties, which exposes us to risks if these parties fail to perform under our agreements with them.

We currently outsource some of our customer service activities and the production of some of our print and photo-based products to third parties. If these parties fail to perform in accordance with the terms of our agreements and if we are unable to secure another outsource partner in a timely manner, we would likely fail to meet customer expectations, which could result in negative publicity, damage our reputation and brand and harm our business and results of operations.

Our net revenues and results of operations are affected by the level of vacation and other travel by our customers, and any declines or disruptions in the travel industry could harm our business.

Because vacation and other travel is one of the primary occasions in which our customers utilize their digital cameras, our net revenues and results of operations are affected by the level of vacation and other travel by our customers. Accordingly, downturns or weaknesses in the travel industry could harm our business.  Travel expenditures are sensitive to business and personal discretionary spending levels and tend to decline during general economic slowdowns such as those experienced in the U.S. and worldwide.  Events or weaknesses that could negatively affect the travel industry include price escalation in the airline industry or other travel-related industries, airline or other travel related strikes, safety concerns, including terrorist activities, pandemic disease (including the influenza virus), inclement weather and airline bankruptcies or liquidations. In addition, high gasoline prices may lead to reduced travel in the United States. Any decrease in vacation or travel could harm our net revenues and results of operations.

Failure to adequately protect our intellectual property could substantially harm our business and results of operations.

We rely on a combination of patent, trademark, trade secret and copyright law and contractual restrictions to protect our intellectual property. These protective measures afford only limited protection. Despite our efforts to protect our proprietary rights, unauthorized parties may attempt to copy aspects of our website features and functionalities or to obtain and use information that we consider proprietary, such as the technology used to operate our website, our production operations and our trademarks.

As of June 30, 2010, we had 35 patents issued and more than 20 patent applications pending in the United States. We intend to pursue corresponding patent coverage in other countries to the extent we believe such coverage is appropriate and cost efficient. We cannot ensure that any of our pending applications will be granted. In addition, third parties have in the past and could in the future bring infringement, invalidity, co-inventorship or similar claims with respect to any of our currently issued patents or any patents that may be issued to us in the future. Any such claims, whether or not successful, could be extremely costly to defend, divert management’s time and attention, damage our reputation and brand and substantially harm our business and results of operations.

 
Our primary brand is “Shutterfly.” We hold registrations for the Shutterfly and other trademarks in our major markets of the United States and Canada, as well as in the European Community, Mexico, Japan, China, Australia and New Zealand. Our competitors may adopt names similar to ours, thereby impeding our ability to build brand identity and possibly leading to customer confusion. In addition, there could be potential trade name or trademark infringement claims brought by owners of marks that are similar to Shutterfly or one of our other marks. The Shutterfly brand is a critical component of our marketing programs. If we lose the ability to use the Shutterfly service mark in any particular market, we could be forced to either incur significant additional marketing expenses within that market, or elect not to sell products in that market. Any claims or customer confusion related to our marks could damage our reputation and brand and substantially harm our business and results of operations.

If we become involved in intellectual property litigation or other proceedings related to a determination of rights, we could incur substantial costs, expenses or liability, lose our exclusive rights or be required to stop certain of our business activities.

Third parties may sue us for infringing their intellectual property rights.  For example, in 2009, we settled three patent infringement lawsuits against us.  Likewise, we may need to resort to litigation to enforce our intellectual property rights or to determine the scope and validity of third-party proprietary rights.

The cost to us of any litigation or other proceeding relating to intellectual property rights, whether or not initiated by us and even if resolved in our favor, could be substantial, and the litigation would divert our management’s efforts from growing our business. Some of our competitors may be able to sustain the costs of complex intellectual property litigation more effectively than we can because they have substantially greater resources. Uncertainties resulting from the initiation and continuation of any litigation could limit our ability to continue our operations.

Alternatively, we may be required to, or decide to, enter into a license with a third party.  Any future license required under any other party’s patents may not be made available on commercially acceptable terms, if at all. In addition, such licenses are likely to be non-exclusive and, therefore, our competitors may have access to the same technology licensed to us. If we fail to obtain a required license and are unable to design around a patent, we may be unable to effectively conduct certain of our business activities, which could limit our ability to generate revenues and harm our results of operations and possibly prevent us from generating revenues sufficient to sustain our operations.

Various governmental legal proceedings, investigations or audits may adversely affect our business and financial performance.

We may be subject to investigations or audits by governmental authorities and regulatory agencies, which can occur in the ordinary course of business or which can result from increased scrutiny from a particular agency towards an industry, country or practice. For example, in April 2009 we and 21 other e-commerce companies were subpoenaed to provide information related to discount programs offered by three membership program companies, including Webloyalty Inc., one of our former business partners.  The resolution of such legal proceedings, investigations or audits could require us to pay substantial amounts of money or take actions that adversely affect our operations. In addition, defending against these claims may involve significant time and expense. Given the visibility of our brand, we may regularly be involved in legal proceedings, government investigations or audits that could adversely affect our business and financial performance.

  We may be subject to past or future liabilities for collection of sales and use taxes, and the payment of corporate level taxes.

Our policies concerning the collection of sales and use taxes and the payment of certain corporate level taxes have been based upon decisions of the U.S. Supreme Court that determine when a taxpayer is deemed to have nexus with a state sufficient to impose tax obligations under the Commerce Clause of the U.S. Constitution. Those Supreme Court decisions require that the taxpayer be physically present before a state can require the collection of sales and use taxes. States are currently attempting to expand the definition of what constitutes physical presence for sales and use taxes.  At the same time, the standard governing the imposition of other taxes, for instance, corporate income taxes, is less established and a number of state courts have concluded that the Commerce Clause definition of nexus should be expanded to include either “physical” or “economic” presence (essentially marketing activities) which is a broader definition than is used for sales and use tax.

We collect sales and use taxes in jurisdictions where we have employees and/or property and in other states where we have implemented joint sales efforts with Target Corporation.

While we believe the U.S. Supreme Court decisions support our policies concerning the collection and payment of taxes, tax authorities could disagree with our interpretations. If sustained, those authorities might seek to impose past as well as future liability for taxes and/or penalties. Such impositions could also impose significant administrative burdens and decrease our future sales. Moreover, the U.S. Congress has been considering various initiatives that could limit or supersede the U.S. Supreme Court’s position regarding sales and use taxes.

Our effective tax rate may be subject to fluctuation from federal and state audits, and stock-based compensation activity.

Future tax audits by taxing agencies for the open tax years could lead to fluctuations in our effective tax rate because the taxing authority may disagree with certain assumptions we have made regarding appropriate credits and deductions in filing our tax returns.

 
Under current stock option tax regulations, our effective tax rate is subject to fluctuations as a result of stock-based compensation activity.  This includes items such as shortfalls associated with the vesting of restricted stock units and restricted stock awards, disqualifying dispositions when employees exercise and sell their incentive stock options within a two year period, and cancellation of vested non-qualified stock options.

Government regulation of the Internet and e-commerce is evolving, and unfavorable changes or failure by us to comply with these regulations could substantially harm our business and results of operations.

We are subject to general business regulations and laws as well as regulations and laws specifically governing the Internet and e-commerce. Existing and future laws and regulations may impede the growth of the Internet or other online services. These regulations and laws may cover taxation, restrictions on imports and exports, customs, tariffs, user privacy, data protection, pricing, content, copyrights, distribution, electronic contracts and other communications, consumer protection, the provision of online payment services, broadband residential Internet access and the characteristics and quality of products and services. It is not clear how existing laws governing issues such as property use and ownership, sales and other taxes, fraud, libel and personal privacy apply to the Internet and e-commerce as the vast majority of these laws were adopted prior to the advent of the Internet and do not contemplate or address the unique issues raised by the Internet or e-commerce. Those laws that do reference the Internet are only beginning to be interpreted by the courts and their applicability and reach are therefore uncertain. For example, the Digital Millennium Copyright Act, or DMCA, is intended, in part, to limit the liability of eligible online service providers for including (or for listing or linking to third-party websites that include) materials that infringe copyrights or other rights of others. Portions of the Communications Decency Act, or CDA, are intended to provide statutory protections to online service providers who distribute third-party content. We rely on the protections provided by both the DMCA and CDA in conducting our business. Any changes in these laws or judicial interpretations narrowing their protections will subject us to greater risk of liability and may increase our costs of compliance with these regulations or limit our ability to operate certain lines of business. The Children’s Online Protection Act and the Children’s Online Privacy Protection Act are intended to restrict the distribution of certain materials deemed harmful to children and impose additional restrictions on the ability of online services to collect user information from minors. In addition, the Protection of Children From Sexual Predators Act of 1998 requires online service providers to report evidence of violations of federal child pornography laws under certain circumstances. The costs of compliance with these regulations may increase in the future as a result of changes in the regulations or the interpretation of them. Further, any failures on our part to comply with these regulations may subject us to significant liabilities. Those current and future laws and regulations or unfavorable resolution of these issues may substantially harm our business and results of operations.

Legislation regarding copyright protection or content interdiction could impose complex and costly constraints on our business model.

Because of our focus on automation and high volumes, our operations do not involve, for the vast majority of our sales, any human-based review of content. Although our website’s terms of use specifically require customers to represent that they have the right and authority to reproduce the content they provide and that the content is in full compliance with all relevant laws and regulations, we do not have the ability to determine the accuracy of these representations on a case-by-case basis. There is a risk that a customer may supply an image or other content that is the property of another party used without permission, that infringes the copyright or trademark of another party, or that would be considered to be defamatory, pornographic, hateful, racist, scandalous, obscene or otherwise offensive, objectionable or illegal under the laws or court decisions of the jurisdiction where that customer lives. There is, therefore, a risk that customers may intentionally or inadvertently order and receive products from us that are in violation of the rights of another party or a law or regulation of a particular jurisdiction. If we should become legally obligated in the future to perform manual screening and review for all orders destined for a jurisdiction, we will encounter increased production costs or may cease accepting orders for shipment to that jurisdiction. That could substantially harm our business and results of operations.

Our practice of offering free products and services could be subject to judicial or regulatory challenge.

We regularly offer free products and free shipping as an inducement for customers to try our products. Although we believe that we conspicuously and clearly communicate all details and conditions of these offers — for example, that customers are required to pay shipping, handling and/or processing charges to take advantage of the free product offer — we may be subject to claims from individuals or governmental regulators that our free offers are misleading or do not comply with applicable legislation. These claims may be expensive to defend and could divert management’s time and attention. If we become subject to such claims in the future, or are required or elect to curtail or eliminate our use of free offers, our results of operations may be harmed.

Any failure by us to protect the confidential information of our customers and networks against security breaches and the risks associated with credit card fraud could damage our reputation and brand and substantially harm our business and results of operations.

A significant prerequisite to online commerce and communications is the secure transmission of confidential information over public networks. Our failure to prevent security breaches could damage our reputation and brand and substantially harm our business and results of operations. For example, a majority of our sales are billed to our customers’ credit card accounts directly, orders are shipped to a customer’s address, and customers log on using their e-mail address. We rely on encryption and authentication technology licensed from third parties to effect the secure transmission of confidential information, including credit card numbers. Advances in computer capabilities, new discoveries in the field of cryptography or other developments may result in a compromise or breach of the technology used by us to protect customer transaction data. In addition, any party who is able to illicitly obtain a user’s password could access the user’s transaction data, personal information or stored images. Any compromise of our security could damage our reputation and brand and expose us to a risk of loss or litigation and possible liability, which would substantially harm our business and results of operations. In addition, anyone who is able to circumvent our security measures could misappropriate proprietary information or cause interruptions in our operations. We may need to devote significant resources to protect against security breaches or to address problems caused by breaches.

 
In addition, contractors that we hire as well as other employees have access to confidential information, including credit card data.  Although we take steps to limit this access, this data could be compromised by these contractors or other employee personnel.  Under current credit card practices, we are liable for fraudulent credit card transactions because we do not obtain a cardholder’s signature. We do not currently carry insurance against this risk. To date, we have experienced minimal losses from credit card fraud, but we continue to face the risk of significant losses from this type of fraud. Our failure to adequately control fraudulent credit card transactions and use of confidential information could damage our reputation and brand and substantially harm our business and results of operations.

The inability to acquire or maintain domain names for our website could substantially harm our business and results of operations.

We currently are the registrant of the Internet domain name for our website, Shutterfly.com, as well as various related domain names. Domain names generally are regulated by Internet regulatory bodies and are controlled also by trademark and other related laws. The regulations governing domain names could change in ways that block or interfere with our ability to use relevant domains. Also, we might not be able to prevent third parties from registering or retaining domain names that interfere with our consumer communications, or infringe or otherwise decrease the value of our trademarks and other proprietary rights. Regulatory bodies also may establish additional generic or country-code top-level domains or modify the requirements for holding domain names. As a result, we might not be able to acquire or maintain the domain names that utilize the name Shutterfly in all of the countries in which we currently or intend to conduct business. This could substantially harm our business and results of operations.

Changes in regulations or user concerns regarding privacy and protection of user data could harm our business.

Federal, state and international laws and regulations may govern the collection, use, sharing and security of data that we receive from our customers. In addition, we have and post on our website our own privacy policies and practices concerning the collection, use and disclosure of customer data. Any failure, or perceived failure, by us to comply with our posted privacy policies or with any data-related consent orders, Federal Trade Commission requirements or other federal, state or international privacy-related laws and regulations could result in proceedings or actions against us by governmental entities or others, which could potentially harm our business. Further, failure or perceived failure to comply with our policies or applicable requirements related to the collection, use or security of personal information or other privacy-related matters could damage our reputation and result in a loss of customers.

International expansion will require management attention and resources and may be unsuccessful, which could harm our future business development and existing domestic operations.

To date, we have conducted limited international operations, but we intend to expand into international markets in order to grow our business. These expansion plans will require significant management attention and resources and may be unsuccessful. We have limited experience adapting our products to conform to local cultures, standards and policies. We may have to compete with local companies which understand the local market better than we do. In addition, to achieve satisfactory performance for consumers in international locations it may be necessary to locate physical facilities, such as production facilities, in the foreign market. We do not have experience establishing, acquiring or operating such facilities overseas. We may not be successful in expanding into any international markets or in generating revenues from foreign operations. In addition, different privacy, censorship and liability standards and regulations and different intellectual property laws in foreign countries may cause our business to be harmed.

The success of our business depends on our ability to adapt to the continued evolution of digital photography.

The digital photography market is rapidly evolving, characterized by changing technologies, intense price competition, additional competitors, evolving industry standards, frequent new service announcements and changing consumer demands and behaviors. To the extent that consumer adoption of digital photography does not continue to grow as expected, our revenue growth would likely suffer. Moreover, we face significant risks that, if the market for digital photography evolves in ways that we are not able to address due to changing technologies or consumer behaviors, pricing pressures, or otherwise, our current products and services may become less attractive, which would result in the loss of customers, as well as lower net revenues and/or increased expenses.

Purchasers of digital photography products and services may not choose to shop online, which would harm our net revenues and results of operations.

The online market for digital photography products and services is less developed than the online market for other consumer products. If this market does not gain widespread acceptance, our business may suffer. Our success will depend in part on our ability to attract customers who have historically used traditional retail photography services or who have produced photographs and other products using self-service alternatives, such as printing at home. Furthermore, we may have to incur significantly higher and more sustained advertising and promotional expenditures or reduce the prices of our products and services in order to attract additional online consumers to our website and convert them into purchasing customers. Specific factors that could prevent prospective customers from purchasing from us include:

 
the inability to physically handle and examine product samples;

 
 
delivery time associated with Internet orders;

 
concerns about the security of online transactions and the privacy of personal information;

 
delayed shipments or shipments of incorrect or damaged products; and

 
inconvenience associated with returning or exchanging purchased items.

If purchasers of digital photography products and services do not choose to shop online, our net revenues and results of operations would be harmed.

The third party software systems that we utilize to assist us in the calculation and reporting of financial data may contain errors that we may not identify in a timely manner.

We use numerous third party licensed software packages, most notably our equity software and our enterprise resource planning (“ERP”) software, which are complex and fully integrated into our financial reporting.  Such third party software may contain errors that we may not identify in a timely manner.  If those errors are not identified and addressed timely, our financial reporting may not be in compliance with generally accepted accounting principles.

For example, since 2006 we have licensed software from a third-party to automate the administration of our employee equity programs and calculate our stock-based compensation expense.  The third-party published a technical bulletin that identified a change to its most current software version to correct computational errors in determining stock-based compensation expense.  In October 2009, we identified that the version of the software we used to calculate stock-based compensation contained the same error and that we had incorrectly calculated stock-based compensation expense. We concluded that it was necessary to restate certain previously issued financial statements for errors in the amount of stock-based compensation recorded.  As a result of identifying the error, we restated our financial statements for the years ended December 31, 2007 and 2008, to record additional stock-based compensation expense of approximately $0.7 million in 2007 and $1.1 million in 2008.

If our internal controls are not effective, there may be errors in our financial information that could require a restatement or delay our SEC filings, and investors may lose confidence in our reported financial information, which could lead to a decline in our stock price.

In October 2009, in connection with the restatement of our financial statements related to our accounting for stock-based compensation expense, we determined that we had a material weakness in our internal controls, which pertained to controls to ensure the completeness and accuracy of stock-based compensation expense.  This weakness resulted in the restatement of our consolidated balance sheets at December 31, 2008 and December 31, 2007, our consolidated statements of operations, stockholders’ equity and cash flows for the fiscal years ended December 31, 2008 and December 31, 2007, and the related notes thereto to correct an error in our stock-based compensation expense.

It is possible that we may discover other significant deficiencies or material weaknesses in our internal control over financial reporting in the future. Any failure to maintain or implement required new or improved controls, or any difficulties we encounter in their implementation, could cause us to fail to meet our periodic reporting obligations, or result in material misstatements in our financial information. Any such delays or restatements could cause investors to lose confidence in our reported financial information and lead to a decline in our stock price.

Maintaining and improving our financial controls and the requirements of being a public company may strain our resources, divert management’s attention and affect our ability to attract and retain qualified board members.

As a public company, we are subject to the reporting requirements of the Securities Exchange Act of 1934, the Sarbanes-Oxley Act of 2002 and the rules and regulations of The NASDAQ Stock Market. Additional or new regulatory requirements may be adopted in the future.  The requirements of existing and potential future rules and regulations will likely continue to increase our legal, accounting and financial compliance costs, make some activities more difficult, time-consuming or costly and may also place undue strain on our personnel, systems and resources.

The Sarbanes-Oxley Act requires, among other things, that we maintain effective disclosure controls and procedures and effective internal control over financial reporting. Significant resources and management oversight are required to design, document, test, implement and monitor internal control over relevant processes and to, remediate any deficiencies. As a result, management’s attention may be diverted from other business concerns, which could harm our business, financial condition and results of operations. These efforts also involve substantial accounting related costs. In addition, if we are unable to continue to meet these requirements, we may not be able to remain listed on The NASDAQ Global Market.

Under the Sarbanes-Oxley Act and the rules and regulations of The NASDAQ Stock Market, we are required to maintain a board of directors with a majority of independent directors. These rules and regulations may make it more difficult and more expensive for us to maintain directors’ and officers’ liability insurance, and we may be required to accept reduced coverage or incur substantially higher costs to maintain coverage. If we are unable to maintain adequate directors’ and officers’ insurance, our ability to recruit and retain qualified directors and officers, especially those directors who may be considered independent for purposes of NASDAQ rules, will be significantly curtailed.

 
If affordable broadband access does not become widely available to consumers, our revenue growth will likely suffer.

Because our business currently involves consumers uploading and downloading large data files, we are highly dependent upon the availability of affordable broadband access to consumers. Many areas of the country still do not have broadband access, and broadband access may be too expensive for many potential customers. To the extent that broadband access is not available or not adopted by consumers due to cost, our revenue growth would likely suffer.

Our stock price may be volatile or may decline regardless of our operating performance.

The market price of our common stock may fluctuate significantly in response to numerous factors, many of which are beyond our control.  In particular, the stock market as a whole recently has experienced extreme price and volume fluctuations that have affected the market price of many technology companies in ways that may have been unrelated to those companies’ operating performance.  Factors that could cause our stock price to fluctuate include:
 
 
slow economic growth and market conditions or trends in our industry or the macro-economy as a whole;

 
price and volume fluctuations in the overall stock market;

 
changes in operating performance and stock market valuations of other technology companies generally, or those in our industry in particular;

 
the financial projections we may provide to the public, any changes in these projections or our failure to meet these projections;

 
changes in financial estimates by any securities analysts who follow our company, our failure to meet these estimates or failure of those analysts to initiate or maintain coverage of our stock;

 
ratings downgrades by any securities analysts who follow our company;

 
the public’s response to our press releases or other public announcements, including our filings with the SEC;

 
announcements by us or our competitors of significant technical innovations, acquisitions, strategic partnerships, joint ventures or capital commitments;

 
introduction of technologies or product enhancements that reduce the need for our products;

 
impairment or loss in value of our investments in auction rate securities;

 
the loss of key personnel;

 
lawsuits threatened or filed against us;

 
future sales of our common stock by our executive officers, directors and significant stockholders; and

 
other events or factors, including those resulting from war, incidents of terrorism or responses to these events.


Some provisions in our restated certificate of incorporation and restated bylaws and Delaware law may deter third parties from acquiring us.

Our restated certificate of incorporation and restated bylaws contain provisions that may make the acquisition of our company more difficult without the approval of our board of directors, including the following:
 
 
our board is classified into three classes of directors, each with staggered three-year terms;

 
only our chairman, our chief executive officer, our president, or a majority of our board of directors is authorized to call a special meeting of stockholders;

 
our stockholders may take action only at a meeting of stockholders and not by written consent;

 
vacancies on our board of directors may be filled only by our board of directors and not by stockholders;

 
our certificate of incorporation authorizes undesignated preferred stock, the terms of which may be established and shares of which may be issued without stockholder approval; and

 
 
advance notice procedures apply for stockholders to nominate candidates for election as directors or to bring matters before an annual meeting of stockholders.

These anti-takeover defenses could discourage, delay or prevent a transaction involving a change in control of our company. These provisions could also discourage proxy contests and make it more difficult for stockholders to elect directors of their choosing and to cause us to take other corporate actions they desire.

In addition, we are subject to Section 203 of the Delaware General Corporation Law, which, subject to some exceptions, prohibits "business combinations" between a Delaware corporation and an "interested stockholder," which is generally defined as a stockholder who becomes a beneficial owner of 15% or more of a Delaware corporation's voting stock, for a three-year period following the date that the stockholder became an interested stockholder.  Section 203 could have the effect of delaying, deferring or preventing a change in control that our stockholders might consider to be in their best interests.

 
ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS
 
Not applicable

ITEM 3. DEFAULTS UPON SENIOR SECURITIES

Not applicable

ITEM 5. OTHER INFORMATION

Not applicable

 
ITEM 6. EXHIBITS
 
Exhibit
Number
 
 Description
10.01   Shutterfly, Inc. 2006 Equity Incentive Plan, as amended (incorporated by reference to Appendix A to the registrant's Definitive Proxy Statement on Schedule 14A filed with the Securities and Exchange Commission on April 7, 2010)
31.01
 
Certification of Chief Executive Officer Pursuant to Securities  Exchange Act Rule 13a-14(a).
31.02
 
Certification of Chief Financial Officer Pursuant to Securities  Exchange Act Rule 13a-14(a).
32.01
 
Certification of Chief Executive Officer Pursuant to 18 U.S.C. Section 1350 and Securities Exchange Act Rule 13a-14(b).*
32.02
 
Certification of Chief Financial Officer Pursuant to 18 U.S.C. Section 1350 and Securities Exchange Act Rule 13a-14(b).*
____________

*
This certification is not deemed “filed” for purposes of Section 18 of the Securities Exchange Act, or otherwise subject to the liability of that section. Such certification will not be deemed to be incorporated by reference into any filing under the Securities Act of 1933 or the Securities Exchange Act of 1934, except to the extent that Shutterfly specifically incorporates it by reference.

 

Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

SHUTTERFLY, INC.
(Registrant)


Dated: July 29, 2010
By: 
/s/ Jeffrey T. Housenbold
   
Jeffrey T. Housenbold
   
President and Chief Executive Officer
   
(Principal Executive Officer)
 
   
Dated: July 29, 2010
By:
/s/ Mark J. Rubash
   
Mark J. Rubash