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EXCEL - IDEA: XBRL DOCUMENT - SHUTTERFLY INCFinancial_Report.xls


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, 2011
or
o
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 
For the transition period from            to

Commission file number 001-33031

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

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

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

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

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

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

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

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

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

Class
Outstanding at July 29, 2011
Common stock, $0.0001 par value per share
34,559,003
 


 
 

 
 
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
41
EXHIBIT 31.01
 
EXHIBIT 31.02
 
EXHIBIT 32.01
 
EXHIBIT 32.02
 
EXHIBIT 101  
 
PART IFINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

Item 1. Condensed Consolidated Financial Statements

SHUTTERFLY, INC.
CONDENSED CONSOLIDATED BALANCE SHEETS
(In thousands, except par value amounts)
(Unaudited)
 
   
June 30,
2011
   
December 31,
2010
 
ASSETS
           
Current assets:
           
Cash and cash equivalents
 
$
75,935
   
$
252,244
 
Accounts receivable, net
   
5,606
     
4,845
 
Inventories
   
3,181
     
3,580
 
Deferred tax asset, current portion
   
327
     
3,582
 
Prepaid expenses and other current assets
   
46,631
     
6,934
 
Total current assets
   
131,680
     
271,185
 
Property and equipment, net
   
46,531
     
39,726
 
Intangible assets, net
   
102,376
     
5,672
 
Goodwill
   
342,730
     
11,163
 
Deferred tax asset, net of current portion
   
-
     
11,314
 
Other assets
   
5,330
     
4,770
 
Total assets
 
$
628,647
   
$
343,830
 
LIABILITIES AND STOCKHOLDERS’ EQUITY
               
Current liabilities:
               
Accounts payable
 
$
4,678
   
$
22,341
 
Accrued liabilities
   
24,733
     
38,831
 
Deferred revenue
   
10,431
     
9,731
 
Total current liabilities
   
39,842
     
70,903
 
Deferred tax liability
   
17,681
     
-
 
Other liabilities
   
5,159
     
3,320
 
Total liabilities
   
62,682
     
74,223
 
Commitments and contingencies (Note 6)
               
Stockholders’ equity
               
Common stock, $0.0001 par value; 100,000 shares authorized; 34,414 and 27,957 shares issued and
outstanding on June 30, 2011 and December 31, 2010, respectively
   
3
     
3
 
Additional paid-in capital
   
571,494
     
263,726
 
Accumulated earnings (deficit)
   
(5,532
)
   
5,878
 
Total stockholders' equity
   
565,965
     
269,607
 
Total liabilities and stockholders' equity
 
$
628,647
   
$
343,830
 
 
The accompanying notes are an integral part of these condensed consolidated financial statements.

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

   
Three Months Ended
June 30,
   
Six Months Ended
June 30,
 
   
2011
   
2010
   
2011
   
2010
 
                         
Net revenues
 
$
75,764
   
$
46,807
   
$
132,993
   
$
92,549
 
Cost of net revenues
   
39,881
     
23,179
     
69,427
     
45,757
 
Gross profit
   
35,883
     
23,628
     
63,566
     
46,792
 
Operating expenses:
                               
Technology and development
   
16,971
     
12,477
     
30,084
     
24,646
 
Sales and marketing
   
24,930
     
11,311
     
39,195
     
21,468
 
General and administrative
   
15,522
     
9,620
     
28,813
     
18,421
 
Total operating expenses
   
57,423
     
33,408
     
98,092
     
64,535
 
Loss from operations
   
(21,540
)
   
(9,780
)
   
(34,526
)
   
(17,743
)
Interest expense
   
-
     
(21
)
   
-
     
(42
)
Interest and other income, net
   
6
     
194
     
20
     
436
 
Loss before income taxes
   
(21,534
)
   
(9,607
)
   
(34,506
)
   
(17,349
)
Benefit from income taxes
   
17,884
     
3,722
     
23,096
     
6,733
 
Net loss
 
$
(3,650
)
 
$
(5,885
)
 
$
(11,410
)
 
$
(10,616
)
                                 
                                 
Net loss per share - basic and diluted
 
$
(0.11
)
 
$
(0.22
)
 
$
(0.37
)
 
$
(0.40
)
                                 
Weighted-average shares outstanding - basic and diluted
   
33,160
     
26,952
     
30,917
     
26,595
 
                                 
                                 
Stock-based compensation is allocated as follows:
                         
                                 
Cost of net revenues
 
$
754
   
$
129
   
$
929
   
$
260
 
Technology and development
   
2,752
     
756
     
3,666
     
1,557
 
Sales and marketing
   
4,156
     
966
     
5,517
     
2,068
 
General and administrative
   
4,437
     
2,208
     
7,222
     
4,548
 
 
The accompanying notes are an integral part of these condensed consolidated financial statements.
 
SHUTTERFLY, INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands)
(Unaudited)

   
Six Months Ended
June 30,
 
   
2011
   
2010
 
Cash flows from operating activities:
           
Net loss
 
$
(11,410
)
 
$
(10,616
)
Adjustments to reconcile net loss to net cash used in operating activities:
               
Depreciation and amortization
   
10,786
     
12,680
 
Amortization of intangible assets
   
4,206
     
1,289
 
Stock-based compensation, net of forfeitures
   
17,334
     
8,433
 
Loss/(gain) on disposal of property and equipment
   
11
     
(88
)
Deferred income taxes
   
-
     
(3,285
)
Tax benefit from stock-based compensation
   
11,585
     
3,710
 
Excess tax benefits from stock-based compensation
   
(11,607
)
   
(4,102
)
Changes in operating assets and liabilities:
               
Accounts receivable, net
   
185
     
2,575
 
Inventories
   
1,311
     
484
 
Prepaid expenses and other current assets
   
(38,149
)
   
(7,905
)
Other assets
   
(887
)
   
(58
)
Accounts payable
   
(20,786
)
   
(6,727
)
Accrued and other liabilities
   
(20,787
)
   
(19,207
)
Deferred revenue
   
194
     
(346
)
Net cash used in operating activities
   
(58,014
)
   
(23,163
)
Cash flows from investing activities:
               
Acquisition of business and intangibles, net of cash acquired
   
(134,036
)
   
-
 
Purchases of property and equipment
   
(9,064
)
   
(8,630
)
Capitalization of software and website development costs
   
(5,044
)
   
(2,049
)
Proceeds from sale of equipment
   
20
     
77
 
Proceeds from the sale of auction rate securities
   
-
     
21,575
 
Net cash provided by (used in) investing activities
   
(148,124
   
10,973
 
Cash flows from financing activities:
               
Principal payments of capital lease obligations
   
(5
)
   
(6
)
Proceeds from issuance of common stock upon exercise of stock options
   
18,227
     
7,884
 
Excess tax benefits from stock-based compensation
   
11,607
     
4,102
 
Net cash provided by financing activities
   
29,829
     
11,980
 
Net decrease in cash and cash equivalents
   
(176,309
)
   
(210
)
Cash and cash equivalents, beginning of period
   
252,244
     
132,812
 
Cash and cash equivalents, end of period
 
$
75,935
   
$
132,602
 
                 
Supplemental schedule of non-cash investing activities
               
Net change in accrued purchases of property and equipment
 
$
193
   
$
914
 
Amount due from adjustment of net working capital from acquired business
   
426
     
-
 
 
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 photo books, cards and stationery and calendars. The Company is headquartered in Redwood City, California.

Basis of Presentation

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

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

Fair Value

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

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

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

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

Income Taxes

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

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



SHUTTERFLY, INC.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

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

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

No new accounting standards have been adopted since the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2010 was filed. Management does not believe that any new accounting pronouncements not yet effective will have a material impact on the Company's financial statements once adopted.

Note 2 — Stock-Based Compensation

Stock Option Activity

A summary of the Company’s stock option activity for the three and six months ended June 30, 2011 is as follows (share numbers and aggregate intrinsic values in thousands):
 
   
Number of Options Outstanding
   
Weighted Average Exercise Price
   
Weighted Average Contractual Term (Years)
   
Aggregate Intrinsic Value
 
Balances, December 31, 2010
   
3,357
   
$
 15.33
             
Granted
   
 75
     
44.70
             
Exercised
   
 (813
)
   
9.15
             
Forfeited, cancelled or expired
   
(12
)
   
19.17
             
Balances, March 31, 2011
   
 2,607
   
$
 18.09
     
6.4
   
$
 89,346
 
Granted
   
16
     
52.72
                 
Exercised
   
(911
)
   
11.83
                 
Forfeited, cancelled or expired
   
(41
)
   
18.72
                 
Increase due to acquisition
   
1,345
     
5.35
                 
Balances, June 30, 2011
   
3,016
   
$
14.48
     
6.9
   
$
129,502
 
Options vested and expected to vest at June 30, 2011
   
2,828
   
$
14.35
     
6.8
   
$
121,814
 
Options vested at June 30, 2011
   
2,177
   
$
13.51
     
6.3
   
$
95,566
 

  During the three months ended June 30, 2011, the Company granted options to purchase an aggregate of 16,000 shares of common stock with an estimated weighted-average grant-date fair value of $23.59 per share. The total intrinsic value of options exercised during the three months ended June 30, 2011, was $42,243,000.  Net cash proceeds from the exercise of stock options were $10,782,000 for the three months ended June 30, 2011.
 

SHUTTERFLY, INC.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

Valuation of Stock Options

The Company estimated the fair value of each option award on the date of grant using the Black-Scholes option-pricing model and the assumptions noted in the following table.  In the three and six months ended June 30, 2011, the Company calculated volatility using an average of its historical and implied volatilities as it had sufficient public trading history to cover the entire expected term.  In all prior periods, expected volatility also included historical and implied volatility of a peer group of publicly traded entities. The expected term of options gave consideration to historical exercises, post-vesting cancellations and the options’ contractual term. The risk-free rate for the expected term of the option is based on the U.S. Treasury Constant Maturity at the time of grant. The assumptions used to value options granted during the three and six months ended June 30, 2011 and 2010 were as follows:
 
   
Three Months Ended
June 30,
   
Six Months Ended
June 30,
 
   
2011
   
2010
   
2011
   
2010
 
Dividend yield
   
     
     
     
 
Annual risk free rate of return
   
1.9
%
   
2.3
%
   
2.1
%
   
2.3
%
Expected volatility
   
53.9
%
   
51.7
%
   
49.1
%
   
50.4
%
Expected term (years)
   
4.3
     
4.5
     
4.4
     
4.6
 

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

Restricted Stock Units

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

Restricted Stock Unit Activity

A summary of the Company’s restricted stock unit activity for the three and six months ended June 30, 2011, is as follows (share numbers in thousands):
 
   
Number of Units Outstanding
   
Weighted Average Grant Date Fair Value
 
Awarded and unvested, December 31, 2010
   
2,019
   
$
15.76
 
Granted
   
723
     
45.13
 
Vested
   
(547
)
   
13.62
 
Forfeited
   
(41
)
   
23.16
 
Awarded and unvested, March 31, 2011
   
2,154
   
$
26.02
 
Granted
   
98
     
53.39
 
Vested
   
(169
)
   
15.50
 
Forfeited
   
(106
)
   
25.22
 
Increase due to acquisition
   
64
     
55.36
 
Awarded and unvested, June 30, 2011
   
2,041
   
$
29.17
 
Restricted stock units expected to vest, June 30, 2011
   
1,590
         
 
 
SHUTTERFLY, INC.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

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

At June 30, 2011, the Company had $67,079,000 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, 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, 2011 and 2010 is as follows (in thousands, except per share amounts):
 
 
Three Months Ended
June 30,
 
Six Months Ended
June 30,
 
 
2011
 
2010
 
2011
 
2010
 
Net loss per share:
                       
Numerator
                       
Net loss
 
$
(3,650
)
 
$
(5,885
)
 
$
(11,410
)
 
$
(10,616
)
 Denominator for basic and diluted net loss per share
                               
Weighted-average common shares outstanding
   
33,160
     
26,952
     
30,917
     
26,595
 
Net loss per share — basic and diluted
 
$
(0.11
)
 
$
(0.22
)
 
$
(0.37
)
 
$
(0.40
)

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

   
Three Months Ended
June 30,
   
Six Months Ended
June 30,
 
   
2011
   
2010
   
2011
   
2010
 
Stock options and restricted stock units
   
5,605
     
5,981
     
5,966
     
6,213
 
 

SHUTTERFLY, INC.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

Note 4 — Fair Value Measurement

The following table represents the Company’s fair value hierarchy for its financial assets as of June 30, 2011 and December 31, 2010 (in thousands):

   
June 30, 2011
 
   
Fair Value
   
Level 1
 
Cash equivalents:
           
Money market funds
 
$
68,705
   
$
68,705
 
Total financial assets
 
$
68,705
   
$
68,705
 

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

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

Note 5 — Balance Sheet Components

Prepaid Expenses and Other Current Assets
 
   
June 30,
2011
   
December 31,
2010
 
   
(in thousands)
 
Intra-period deferred tax asset
 
 $
34,681
   
 $
-
 
Prepaid service contracts – current portion
   
4,129
     
3,189
 
Prepaid income taxes
   
1,231
     
611
 
Other prepaid expenses and current assets
   
6,590
     
3,134
 
   
$
46,631
   
$
6,934
 
 
Intra-period deferred tax asset includes $11.6 million in excess tax benefits from stock-based compensation, that will offset against taxes payable on a full year basis.  
 
Property and Equipment

   
June 30,
2011
   
December 31,
2010
 
   
(in thousands)
 
Computer and other equipment
 
$
95,819
   
$
87,531
 
Software
   
10,349
     
9,124
 
Leasehold improvements
   
8,723
     
7,133
 
Furniture and fixtures
   
3,682
     
3,006
 
Capitalized software and website development costs
   
30,593
     
25,173
 
     
149,166
     
131,967
 
Less: Accumulated depreciation and amortization
   
(102,635
)
   
(92,241
)
Net property and equipment
 
$
46,531
   
$
39,726
 

Depreciation and amortization expense totaled $5,672,000 and $6,307,000 for the three months ended June 30, 2011 and 2010, respectively.  Depreciation and amortization expense totaled $10,786,000 and $12,680,000 for the six months ended June 30, 2011 and 2010, respectively.
 
 
SHUTTERFLY, INC.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

Accrued Liabilities
 
   
June 30,
  2011
   
December 31,
2010
 
   
(in thousands)
 
Accrued marketing expenses
 
$
6,587
   
$
11,766
 
Accrued compensation
   
5,249
     
5,701
 
Accrued production costs
   
3,803
     
8,551
 
Accrued income and sales taxes
   
3,037
     
7,342
 
Accrued consulting
   
1,370
     
1,750
 
Accrued other
   
4,687
     
3,721
 
   
$
24,733
   
$
38,831
 
 
 Note 6 — Commitments and Contingencies

Indemnifications

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

Contingencies

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

Legal Matters

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

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

In addition to the above cases, from time to time, the Company may be involved in various legal proceedings arising in the ordinary course of business.  In all cases, at each reporting period, the Company evaluates whether or not a potential loss amount or a potential range of loss is probable and reasonably estimable under the provisions of the authoritative guidance that addresses accounting for contingencies.  In such cases, the Company accrues for the amount, or if a range, the Company accrues the low end of the range as a component of legal expense.

Note 7 — Acquisition

On April 25, 2011, the Company acquired Tiny Prints, Inc. (“Tiny Prints”), a privately-held ecommerce company.  Pursuant to the terms of the agreement, all of the outstanding shares of capital stock of Tiny Prints, together with vested and unvested Tiny Prints equity awards, were acquired by the Company for aggregate consideration comprised of (i) approximately $146.5 million in cash, and approximately 4.0 million shares of the Company’s common stock issuable in exchange for shares of Tiny Prints capital stock and (ii) Company equity awards for approximately 1.4 million shares of common stock in exchange for vested and unvested Tiny Prints’ equity awards assumed by the Company, in each case pursuant and subject to the terms of the Merger Agreement. The 5.4 million shares of Shutterfly common stock issuable pursuant to the agreement equal approximately 18.5% of the Company’s outstanding common stock as of March 30, 2011.

During the three months ended June 30, 2011, the Company finalized the Net Working Capital, Net Cash, and Net Debt amounts resulting in a reduction of purchase price of approximately $1.1 million.  In accordance with the merger agreement, this amount will be repaid from the consideration held in escrow in the same proportion of cash and stock as was made in the initial escrow contribution.  As of June 30, 2011, the cash proceeds due from escrow have been accrued as a component of other current assets.
 
Purchase Price
 
The total purchase price, after adjusting for changes in Net Working Capital, Net Cash, and Net Debt, is as follows (in thousands):
 
Cash consideration
 
$
146,119
 
Fair value of common stock issued
   
218,677
 
Fair value of vested stock awards assumed
   
41,766
 
Total fair value of consideration transferred
 
$
406,562
 
 
Tiny Prints operates tinyprints.com and weddingpaperdivas.com which offer cards, invitations, personalized stationery and photo books.  With the acquisition and combined resources, the Company expects to incur significant revenue and cost synergies through the Tiny Prints brands, customer base and workforce.
 
Estimated Fair Value of Stock Awards Assumed

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

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

Purchase Price Allocation

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

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

   
Amount
   
Estimated Useful Life (in years)
 
                 
Total assets acquired
 
$
19,235
     
N/A
 
Total liabilities assumed
   
(44,218
)
   
N/A
 
Identifiable intangible assets:
               
Trade Name
   
51,100
     
15
 
Customer Base
   
33,300
     
7
 
Developed Technology
   
12,500
     
4
 
Other
   
3,080
     
2-3
 
Goodwill
   
331,565
     
N/A
 
Total purchase price
 
$
406,562
         
 
Included in the total liabilities assumed is a net deferred tax liability balance of $32.2 million, primarily comprised of the difference between the assigned values of the tangible and intangible assets acquired and the tax basis of those assets. This amount is net of deferred tax assets related to vested non-qualified stock options included in the purchase price, as well as other deferred tax assets acquired in the transaction.

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

Goodwill of $331.6 million represents the excess of the purchase price over the fair value of the underlying net tangible and identifiable intangible assets, and represents the expected synergistic benefits of the transaction and the knowledge and experience of the workforce in place. In accordance with applicable accounting standards, goodwill will not be amortized but instead will be tested for impairment at least annually, or, more frequently if certain indicators are present. In the event that the management of the combined company determined that the value of goodwill has become impaired, the combined company will incur an accounting charge for the amount of the impairment during the fiscal quarter in which the determination is made.
 
The following table presents the pro forma statements of operations obtained by combining the historical consolidated operations of the Company and Tiny Prints for the three and six months ended June 30, 2011 and 2010, giving effect to the merger as if it occurred on January 1, 2011 and 2010, respectively (in thousands, except per share data):

   
Three Months Ended
June 30,
   
Six Months Ended
June 30,
 
   
2011
   
2010
   
2011
   
2010
 
Pro forma net revenues
 
$
81,508
   
$
61,017
   
$
158,771
   
$
119,969
 
Pro forma net loss
   
(4,537
)
   
(6,889
)
   
(14,369
)
   
(11,104
)
Pro forma basic and diluted net loss per share
 
$
(0.14
 
$
(0.26
 
(0.46
 
$
(0.42
 
Included in net revenues for the three and six months ended June 30, 2011 is $14.7 million of net revenues from sales of Tiny Prints products from the acquisition date of April 25, 2011 through June 30, 2011.
 
 
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 and growth of our business, the impact on us of general economic conditions, trends in key metrics such as number of customers and orders and average order value, the decline in average selling prices for prints, our capital expenditures for 2011, the sufficiency of our cash and cash equivalents and cash generated from operations for the next 12 months, our ability to grow our personalized products and services as a percentage of our total revenues, our operating expenses remaining a consistent percentage of our net revenues, as well as other statements regarding our future operations, financial condition and prospects and business strategies. In some cases, you can identify forward-looking statements by terminology such as “project,” “believe,” “anticipate,” “plan,” “expect,” “estimate,” “intend,” “continue,” “should,” “would,” “could,” “potentially,” “will,” or “may,” or the negative of these terms or other comparable terminology. Forward-looking statements involve risks and uncertainties. Our actual results and the timing of events could differ materially from those anticipated in our forward-looking statements as a result of many factors, including but not limited to, the seasonality of our business, whether we are able to expand our customer base and increase our product and service offering, competition in our marketplace and the other risks set forth below under “Risk Factors” in Part II, Item 1A of this report. Given these risks and uncertainties, readers are cautioned not to place undue reliance on such forward-looking statements. We assume no obligation to update any of the forward-looking statements after the date of this report or to compare these forward-looking statements to actual results.

Overview

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

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

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

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

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

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

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

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

Prints
 
We also generate revenue from photo prints and the associated shipping revenue.  Photo prints consist of wallet, 2x3, 4x6, 5x7, 8x10, and large format sizes.  Also included in print revenues are photocards, which are personalized silver halide photo prints with designed content, used for greeting card occasions ranging from holidays to birthday cards and thank you notes.

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

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

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

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

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

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

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

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

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

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

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

General and administrative expense includes general corporate costs, such as rent for our corporate offices, insurance, depreciation on information technology equipment, and legal and accounting fees. Transaction costs related to our acquisition of Tiny Prints are also included in general and administrative expense.  In addition, general and administrative expense includes personnel expenses of employees involved in executive, finance, accounting, human resources, information technology and legal roles. Third-party payment processor and credit card fees are also included in general and administrative expense and have historically fluctuated based on revenues during the period. All of the payments we have received from our intellectual property license agreements have been included as an offset to general and administrative expense.   We recognized a final payment due from one of the agreements in the first quarter of fiscal year 2010.

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

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

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

 Critical Accounting Policies and Estimates

The discussion and analysis of our financial condition and results of operations are based upon our unaudited condensed consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses. On an on-going basis, we evaluate our critical accounting policies and estimates. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. Our critical accounting policies and estimates are discussed in our Annual Report on Form 10-K for the fiscal year ended December 31, 2010.
 
 
Results of Operations

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

   
Three Months Ended
   
Six Months Ended
 
   
June 30,
   
June 30,
 
   
2011
   
2010
   
2011
 
2010
 
Net revenues
   
100
%
   
100
%
   
100
%
   
100
%
Cost of net revenues
   
53
%
   
50
%
   
52
%
   
49
%
Gross profit
   
47
%
   
50
%
   
48
%
   
51
%
Operating expenses:
                               
Technology and development
   
22
%
   
27
%
   
23
%
   
27
%
Sales and marketing
   
33
%
   
24
%
   
29
%
   
23
%
General and administrative
   
20
%
   
21
%
   
22
%
   
20
%
Loss from operations
   
(28
)%
   
(22
)%
   
(26
)%
   
(19
)%
Interest expense
   
0
%
   
0
%
   
0
%
   
0
%
Interest and other income, net
   
0
%
   
1
%
   
0
%
   
1
%
Loss before income taxes
   
(28
)%
   
(21
)%
   
(26
)%
   
(18
)%
Benefit from income taxes
   
23
%
   
8
%
   
17
%
   
7
%
Net loss
   
(5
)%
   
(13
)%
   
(9
)%
   
(11
)%
 
Comparison of the Three Month Periods Ended June 30, 2011 and 2010
 
 
Three Months Ended June 30,
 
 
2011
 
2010
 
$ Change
   
% Change
 
 
(in thousands)
 
Net revenues
                               
Personalized products and services
 
$
58,531
   
$
31,676
   
$
26,855
     
85
%
Prints
   
14,491
     
14,371
     
120
     
1
 
Commercial printing services
   
2,742
     
760
     
1,982
     
261
 
Total net revenues
   
75,764
     
46,807
     
28,957
     
62
 
Cost of net revenues
   
39,881
     
23,179
     
16,702
     
72
 
Gross profit
 
$
35,883
   
$
23,628
   
$
12,255
     
52
%
Percentage of net revenues
   
47
%
   
50
%
   
     
 

Net revenues increased $29.0 million, or 62%, for the three months ended June 30, 2011 as compared to the same period in 2010.  Revenue growth was attributable to increases in all revenue categories.   PPS revenues increased $26.9 million, or 85%, to $58.5 million in the three months ended June 30, 2011 compared to the same period in 2010. The increase in PPS is primarily a result of increased sales of photo books and greeting and stationery cards.  In addition, PPS includes $14.7 million of revenues from sales of Tiny Prints greeting card and stationery products from the acquisition date of April 25, 2011 through June 30, 2011.    Print revenue increased $0.1 million, or 1%, to $14.5 million in the three months ended June 30, 2011 compared to the same period in 2010.  Print revenues from sales of 4x6 prints represented 9% of total net revenues for the three months ended June 30, 2011, versus 16% in the prior year.   In terms of product mix, PPS represented 77% and Prints represented 19% of revenue in the three months ended June 30, 2011.  This compares to 68% and 31% in the same period in 2010.    Revenue from our commercial print services increased $2.0 million, or 261%, to $2.7 million for the three months ended June 30, 2011, representing 4% of our total net revenues in the three months ended June 30, 2011.

For Shutterfly, 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,
 
 
2011
 
2010
 
$ Change
   
% Change
 
Shutterfly    
(in thousands, except AOV amounts)  
 
Customers
   
1,413
     
1,118
     
295
     
26
%
Orders
   
2,235
     
1,802
     
433
     
24
%
Average order value
 
$
26.10
   
$
25.56
   
$
0.54
     
2
%
 
 
On a pro forma basis, comparing the full three months ended June 30, 2011 to the three months ended June 30, 2010, Tiny Prints key metrics, also increased, as noted below:

 
Three Months Ended June 30,
 
 
2011
 
2010
 
$ Change
   
% Change
 
Tiny Prints
(in thousands, except AOV amounts)
 
Customers
   
224
     
134
     
90
     
67
%
Orders
   
362
     
162
     
200
     
124
%
Average order value (excluding one-to-one greeting cards)
 
$
112.13
   
$
100.17
   
$
11.96
     
12
%

Cost of net revenues increased $16.7 million, or 72%, for the three months ended June 30, 2011 as compared to the same period in 2010. As a percentage of net revenues, cost of net revenues increased to 53% in 2011 from 50% in 2010, which decreased gross margin to 47% in the three months ended June 30, 2011 from 50% in the same period in 2010. Overall, the increase in cost of net revenues was primarily the result of the increased volume of shipped products, increased headcount and greater third-party fulfillment costs associated with Tiny Prints products. These costs were partially offset by favorable improvements from product mix.

   
Three Months Ended June 30,
 
   
2011
   
2010
   
$ Change
   
% Change
 
   
(in thousands)
 
Technology and development
 
$
16,971
   
$
12,477
   
$
4,494
     
36
%
Percentage of net revenues
   
22
%
   
27
%
   
-
     
-
 
Sales and marketing
 
$
24,930
   
$
11,311
   
$
13,619
     
120
%
Percentage of net revenues
   
33
%
   
24
%
   
-
     
-
 
General and administrative
 
$
15,522
   
$
9,620
   
$
5,902
     
61
%
Percentage of net revenues
   
20
%
   
21
%
   
-
     
-
 

Our technology and development expense increased $4.5 million, or 36%, for the three months ended June 30, 2011, as compared to the same period in 2010. As a percentage of net revenues, technology and development expense decreased to 22% for the three months ended June 30, 2011 from 27% for the same period in 2010. The increase in technology and development expense was primarily due to an increase of $2.6 million related to personnel and related costs for employees, $2.0 million of stock-based compensation, $1.2 million related to professional and outside services consultants involved with website development and website infrastructure support teams and $0.4 million related to facilities costs.  These factors were partially offset by a decrease in depreciation expense of $0.7 million and higher website development costs capitalized in the current period compared to the same period in the prior year.

At June 30, 2011, headcount in technology and development increased by 55% compared to June 30, 2010 reflecting our strategic focus to increase the rate of innovation in our product and services offerings, to generate greater differentiation from our competitors, and improve our long-term operating efficiency.  In addition, the increase in headcount is also the result of the completion of the Tiny Prints acquisition during the period. As a result, in the three months ended June 30, 2011, we capitalized $2.4 million in eligible salary and consultant costs, including $0.1 million of stock based compensation, associated with software developed or obtained for internal use, compared to $1.3 million, which included $0.1 million of stock based compensation capitalized in the three months ended June 30, 2010.  We expect this trend to continue in 2011, further increasing capitalized website and software development costs as a percentage of our total capital expenditures.

Our sales and marketing expense increased $13.6 million, or 120%, in the three months ended June 30, 2011 compared to the same period in 2010.  As a percentage of net revenues, total sales and marketing expense increased to 33% in the three months ended June 30, 2011 from 24% in the three months ended June 30, 2010. The increase in sales and marketing expense was primarily due to an increase of $5.8 million related to expanded online marketing and partner marketing campaigns, as well as an increase of $3.2 million in stock-based compensation, and $2.1 million for depreciation.  Personnel and related costs increased $2.3 million  due to the additional headcount from our acquisition of Tiny Prints as well as the expansion of our existing marketing team.

Our general and administrative expense increased $5.9 million, or 61%, in the three months ended June 30, 2011 as compared to the same period in 2010.  As a percentage of net revenues, total general and administrative expense decreased slightly to 20% for the three months ended June 30, 2011 from 21% in the three months ended June 30, 2010. The increase in general and administrative expense is primarily due to an increase in stock-based compensation of $2.2 million, an increase in personnel related costs of $1.6 million as a result of increased headcount, $0.9 million in transaction costs and $0.3 million related to facility costs.  In the three months ended June 30, 2011, we also incurred an increase in credit card fees of $0.7 million which was driven by the increase in consumer product revenue as compared to the same period in 2010.  

   
Three Months Ended June 30,
 
   
2011
   
2010
   
Change
 
   
(in thousands)
 
Interest expense
 
$
-
   
$
(21
)
 
$
(21
)
Interest and other income, net
 
$
6
   
$
194
   
$
(188
)
 
 
Interest expense decreased in the three months ended June 30, 2011 as compared to the same period in 2010 primarily due to the expiration of our $20.0 million line of credit facility with Silicon Valley Bank on June 23, 2010, which we did not renew.
 
Interest and other income, net decreased by $0.2 million for the three months ended June 30, 2011 compared to the same period in 2010. The decrease was primarily due to the liquidation of our ARS investments on July 1, 2010, which yielded higher returns and were subsequently invested in Treasury securities, which yielded lower returns.

 
Three Months Ended
June 30,
 
 
2011
 
2010
 
 
(in thousands)
 
Income tax benefit
 
$
17,884
   
$
3,722
 
Effective tax rate
   
83
%
   
39
%

The benefit for income taxes was $17.9 million for the three months ended June 30, 2011, compared to a benefit of $3.7 million for the three months ended June 30, 2010.  Our effective tax rate was 83% in the three months ended June 30, 2011, compared to 39% in the same period in 2010, primarily reflecting non-deductible stock-based compensation and transaction expenses, offset by tax benefits resulting from disqualifying dispositions of employee incentive stock options during the period.
 
   
Three Months Ended June 30,
 
   
2011
   
2010
   
$ Change
   
% Change
 
   
(in thousands)
 
Loss before income taxes
 
$
(21,534
)
 
$
(9,607
)
 
$
(11,927
)
   
124
%
Net loss
 
$
(3,650
)
 
$
(5,885
)
 
$
2,235
     
(38
)%
Percentage of net revenues
   
(5
) %
   
(13
) %
   
    —
     
 

Net loss decreased by $2.2 million for the three months ended June 30, 2011 as compared to the same period in 2010. As a percentage of net revenue, net loss was 5% and 13% for the three months ended June 30, 2011 and June 30, 2010, respectively.

Comparison of the Six Month Period Ended June 30, 2011 and 2010

 
Six Months Ended June 30,
 
 
2011
 
2010
 
$ Change
   
% Change
 
 
(in thousands)
 
Net revenues
                               
Personalized products and services
 
$
99,330
   
$
62,170
   
$
37,160
     
60
%
Prints
   
28,644
     
28,107
     
537
     
2
 
Commercial printing services
   
5,019
     
2,272
     
2,747
     
121
 
Total net revenues
   
132,993
     
92,549
     
40,444
     
44
 
Cost of net revenues
   
69,427
     
45,757
     
23,670
     
52
 
Gross profit
 
$
63,566
   
$
46,792
   
$
16,774
     
36
%
Percentage of net revenues
   
48
%
   
51
%
   
     
 
 
Net revenues increased $40.4 million, or 44%, for the six months ended June 30, 2011 as compared to the same period in 2010.  Revenue growth was attributable to increases in all revenue categories.   PPS revenues increased $37.2 million, or 60%, to $99.3 million in the six months ended June 30, 2011 compared to the same period in 2010. The increase in PPS is primarily a result of increased sales of photo books and greeting and stationery cards. In addition, PPS includes $14.7 million of revenues from sales of Tiny Prints greeting card and stationery products from the acquisition date of April 25, 2011 through June 30, 2011.   Print revenue increased $0.5 million, or 2%, to $28.6 million in the six months ended June 30, 2011 compared to the same period in 2010.  The overall increase in print revenue was primarily due to an increase in large format prints offset by a decrease in photocard revenue and 4x6 print revenue, which represented 11% of total net revenues versus 16% in the prior year.   In terms of product mix, PPS represented 77% and Prints represented 19% of revenue in the three months ended June 30, 2011.  This compares to 67% and 31% in the same period in 2010.    Revenue from our commercial print services increased $2.7 million, or 121%, to $5.0 million for the six months ended June 30, 2011, compared to the same period in 2010, and represented 4% of our total net revenues in the six months ended June 30, 2011.
 
 
Cost of net revenues increased $23.7 million, or 52%, for the six months ended June 30, 2011 as compared to the same period in 2010. As a percentage of net revenues, cost of net revenues increased slightly to 52% in 2011 from 49% in 2010, which decreased gross margin to 48% in the six months ended June 30, 2011 from 51% in the same period in 2010. Overall, the increase in cost of net revenues was primarily the result of the increased volume of shipped products and increased headcount, as well as additional third party fulfillment costs associated with Tiny Prints products. These costs were partially offset by favorable improvements from product mix.

   
Six Months Ended June 30,
 
   
2011
   
2010
   
$ Change
 
% Change
 
   
(in thousands)
 
Technology and development
 
$
30,084
   
$
24,646
   
$
5,438
   
22
%
Percentage of net revenues
   
23
%
   
27
%
   
 -
   
 -
 
Sales and marketing
 
$
39,195
   
$
21,468
   
$
17,727
   
83
%
Percentage of net revenues
   
29
%
   
23
%
   
 -
   
 -
 
General and administrative
 
$
28,813
   
$
18,421
   
$
10,392
   
56
%
Percentage of net revenues
   
22
%
   
20
%
   
 -
   
 -
 

Our technology and development expense increased $5.4 million, or 22%, for the six months ended June 30, 2011, as compared to the same period in 2010. As a percentage of net revenues, technology and development expense decreased to 23% for the six months ended June 30, 2011 from 27% for the same period in 2010. The increase in technology and development expense was primarily due to an increase of $3.9 million related to personnel and related costs for employees, an increase of $2.4 million related to professional and outside services consultants involved with website development and website infrastructure support teams, $2.1 million of stock-based compensation and $0.9 million related to facilities costs.  These factors were partially offset by a decrease in depreciation expense of $1.6 million and higher website development costs capitalized in the current period compared to the same period in the prior year.

In the six months ended June 30, 2011, we capitalized $4.7 million in eligible salary and consultant costs, including $0.2 million of stock based compensation, associated with software developed or obtained for internal use, compared to $2.2 million, which included $0.1 million of stock based compensation capitalized in the six months ended June 30, 2010.  We expect this trend to continue in 2011, further increasing capitalized website and software development costs as a percentage of our total capital expenditures.

Our sales and marketing expense increased $17.7 million, or 83%, in the six months ended June 30, 2011 compared to the same period in 2010.  As a percentage of net revenues, total sales and marketing expense increased to 29% from 23%. The increase in sales and marketing expense was primarily due to an increase of $8.4 million related to expanded online marketing and partner marketing campaigns.  The increase is also attributable to an increase of $3.4 million in personnel and related costs associated with our acquisition of Tiny Prints as well as the expansion of our internal marketing team, an increase of $3.4 million in stock based compensation, $2.1 million in depreciation and $0.4 million for professional fees.

Our general and administrative expense increased $10.4 million, or 56%, in the six months ended June 30, 2011 as compared to the same period in 2010.  As a percentage of net revenues, total general and administrative expense increased to 22% in the six months ended June 30, 2011 from 20% for the comparable period in 2010. The increase in general and administrative expense is primarily due to an increase in personnel related costs of $3.1 million as a result of increased headcount, $2.7 million in stock-based compensation, $2.2 million in transaction costs related to our acquisition of Tiny Prints and $0.4 million for facility costs offset by a decrease  in professional fees of $0.9 million.  In the six months ended June 30, 2011, we also incurred an increase in credit card fees of $1.1 million which was driven by the increase in consumer product revenue as compared to the same period in 2010.  During the six months ended June 30, 2010, we received the final installment from a cross-licensing agreement, while in the current period we received no installments. These payments were recognized as reductions of general and administrative expense. 

   
Six Months Ended June 30,
 
   
2011
   
2010
   
Change
 
   
(in thousands)
 
Interest expense
 
$
-
   
$
(42
)
 
$
(42
Interest and other income, net
 
$
20
   
$
436
   
$
(416
)

Interest expense decreased in the six months ended June 30, 2011 as compared to the same period in 2010 primarily due to the expiration of our $20.0 million line of credit facility with Silicon Valley Bank on June 23, 2010, which we did not renew.
 
Interest and other income, net decreased by $0.4 million for the six months ended June 30, 2011 compared to the same period in 2010. The decrease was primarily due to the liquidation of our ARS investments on July 1, 2010, which yielded higher returns and were subsequently invested in Treasury securities, which yielded lower returns.
 
 
 
Six Months Ended June 30,
     
2011
     
2010
 
     
(in thousands)
 
Income tax benefit
 
$
23,096
   
$
6,733
 
Effective tax rate
   
67
%
   
39
%

The benefit for income taxes was $23.1 million for the six months ended June 30, 2011, compared to a benefit of $6.7 million for the six months ended June 30, 2010.  Our effective tax rate was 67% in the six months ended June 30, 2011, compared to 39% in the same period in 2010, primarily reflecting non-deductible stock-based compensation and transaction expenses, offset by tax benefits resulting from disqualifying dispositions of employee incentive stock options during the period.
 
   
Six Months Ended June 30,
 
   
2011
   
2010
   
$ Change
   
% Change
 
   
(in thousands)
 
Loss before income taxes
 
$
(34,506
)
 
$
(17,349
)
 
$
(17,157
)
   
99
%
Net loss
 
$
(11,410
)
 
$
(10,616
)
 
$
(794
)
   
7
%
Percentage of net revenues
   
(9
) %
   
(11
) %
   
    —
     
 

Net loss increased by $0.8 million for the six months ended June 30, 2011 as compared to the same period in 2010. As a percentage of net revenue, net loss was 9% and 11% for the six months ended June 30, 2011 and June 30, 2010, respectively.

Liquidity and Capital Resources
 
 
Six Months Ended June 30,
 
 
2011
 
2010
 
 
(in thousands)
 
Consolidated Statements of Cash Flows Data:
       
Purchases of property and equipment
 
$
9,064
   
$
8,630
 
Capitalization of software and website development costs
   
5,044
     
2,049
 
Depreciation and amortization
   
14,992
     
13,969
 
Cash flows used in operating activities
   
(58,014
)
   
(23,163
)
Cash flows provided by (used in) investing activities
   
(148,124
   
10,973
 
Cash flows provided by financing activities
   
29,829
     
11,980
 

We anticipate that our current cash and cash equivalents balances and cash generated from operations will be sufficient to meet our strategic and working capital requirements, lease obligations, expansion plans, and technology development projects for at least the next twelve months. Whether these resources are adequate to meet our liquidity needs beyond that period will depend on our growth, operating results and the capital expenditures required to meet possible increased demand for our products. If we require additional capital resources to grow our business internally or to acquire complementary technologies and businesses at any time in the future, we may seek to 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.
 
We anticipate that total 2011 capital expenditures will range from 7.0% to 7.5% of our expected net revenues in 2011.  These expenditures will be used to purchase technology and equipment to support the growth in our business and to increase our production capacity and help enable us to respond more quickly and efficiently to customer demand. An increasing component of these expenditures includes costs associated with capitalized software and website development, as we continue to support our innovative engineering and product development strategies.
 

The following table shows total capital expenditures by category for the six months ended June 30, 2011 and 2010 (in thousands):

   
Six Months Ended
June 30,
 
   
2011
   
2010
 
Technology equipment and software
 
$
5,665
   
$
7,688
 
Percentage of total capital expenditures
   
40
%
   
66
%
Manufacturing equipment and building improvements
   
3,591
     
1,856
 
Percentage of total capital expenditures
   
25
%
   
16
%
Capitalized technology and development costs
   
5,045
     
2,049
 
Percentage of total capital expenditures
   
35
%
   
18
%
Total Capital Expenditures
 
$
14,301
   
$
11,593
 
Total Capital Expenditures percentage of net revenues
   
11
%
   
13
%

During the six months ended June 30, 2011, as we continued to increase the rate of innovation in our product and services offerings, to generate greater differentiation from our competitors, and improve our long-term operating efficiency, the percentage of total capital expenditures associated with website and product development has increased to 35% in the six months ended June 30, 2011 from 18% in the comparable period in 2010.

Also in the six months ended June 30, 2011, we incurred approximately $1.9 million in capital expenditures associated with building improvements to our headquarters facility.  We expect these leasehold improvements to be reimbursed under our current lease, which was renewed in March 2010. Reimbursements under this provision have been recorded as a deferred lease incentive and will reduce rent expense over the remaining lease term.  We expect to utilize the remaining reimbursement allowance during 2011.

Operating Activities. For the six months ended June 30, 2011, net cash used in operating activities was $58.0 million, primarily due to our net loss of $11.4 million and the net change in operating assets and liabilities of $78.9 million largely due to payments of  year-end obligations.  Net cash used in operating activities was adjusted for non-cash items including $10.8 million of depreciation and amortization expense and $17.3 million of stock-based compensation. Another non-cash item included in operating activities is $4.2 million of amortization of intangible assets which includes $0.2 million of amortization of prepaid royalties associated with intellectual property licenses that were entered into since 2009.

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.

Investing Activities. For the six months ended June 30, 2011, net cash used in investing activities was $148.1 million.  We used $146.5 million in the acquisition of Tiny Prints net of cash acquired, $9.1 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 $5.0 million of capitalized software and website development.  

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.

Financing Activities. For the six months ended June 30, 2011, net cash provided by financing activities was $29.8 million, primarily from $18.2 million of proceeds from issuance of common stock from the exercise of options and $11.6 million from excess tax benefits from stock-based compensation.

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.

 
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, 2011 and 2010 (in thousands):
 
 
Three Months Ended
June 30,
 
Six Months Ended
June 30,
 
 
2011
 
2010
 
2011
 
2010
 
     
Net revenues
  $ 75,764     $ 46,807     $ 132,993     $ 92,549  
                                 
 Non-GAAP Adjusted EBITDA
  $ (282   $ 1,228     $ (2,200 )   $ 4,659  
EBITDA % of Net revenues
    0 %     3 %     (2 )%     5 %
                                 
Free cash flow
  $ (6,819 )   $ (4,029 )   $ (16,501 )   $ (6,934 )
Free cash flow % of Net revenues
    (9 )%     (9 )%     (12 )%     (7 )%

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.  For the three and six months ended June 30, 2011, our adjusted EBITDA was ($0.3) million and ($2.2) million, respectively, as compared to $1.2 million and $4.7 million in the same periods in 2010.  This adjusted EBITDA decline resulted from various discrete items, including intellectual property licensing and referral fees of $4.1 million in the six months ended June 30, 2010, and acquisition costs of $2.2 million and incremental payroll taxes related to employee equity awards of $1.1 million in the six months ended June 30, 2011.  After adjusting for these discrete items, for the six months ended June 30, 2011, adjusted EBITDA would have increased $0.5 million compared to the prior year.   

 During the six months ended June 30, 2011 and 2010, we experienced negative free cash flows of $16.5 million and $6.9 million, respectively. However, during the fiscal year, we take steps designed to preserve the opportunity to achieve full year positive free cash flows.  For example, on an annual basis, our capital expenditures have decreased each year from 2008 to 2010, 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.
 
 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.  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, 2011 and 2010 (in thousands):
 
  Reconciliation of Net Loss to Non-GAAP Adjusted EBITDA
 
Three Months Ended
   
Six Months Ended
 
   
June 30,
   
June 30,
 
   
2011
   
2010
   
2011
   
2010
 
       
Net loss
 
$
(3,650
)
 
$
(5,885
)
 
$
(11,410
)
 
$
(10,616
)
Add back:
                               
Interest expense
   
-
     
21
     
-
     
42
 
Interest and other income, net
   
(6
)
   
(194
)
   
(20
)
   
(436
)
Tax benefit
   
(17,884
)
   
(3,722
)
   
(23,096
)
   
(6,733
)
Depreciation and amortization
   
9,159
     
6,949
     
14,992
     
13,969
 
Stock-based compensation expense
   
12,099
     
4,059
     
17,334
     
8,433
 
Non-GAAP Adjusted EBITDA
 
$
(282)
   
$
1,228
   
$
(2,200)
   
$
4,659
 
                                 
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,
 
     
2011
     
2010
     
2011
     
2010
 
       
Net cash used in operating activities
 
$
(5,165
 
$
5,101
   
$
(58,014
)
 
$
(23,163
)
Add back:
                               
Interest expense
   
-
     
21
     
-
     
42
 
Interest and other income, net
   
(6
)
   
(194
)
   
(20
)
   
(436
)
Tax benefit
   
(17,884
)
   
(3,722
)
   
(23,096
)
   
(6,733
)
Changes in operating assets and liabilities
   
23,217
     
(1,969
)
   
78,919
     
31,184
 
Other adjustments
   
(444
   
1,991
     
11
     
3,765
 
Non-GAAP Adjusted EBITDA
   
(282)
     
1,228
     
(2,200)
     
4,659
 
Less:
                               
Purchases of property and equipment, including accrued amounts
   
(3,811
)
   
(4,010
)
   
(9,257
)
   
(9,544
)
Capitalized technology & development costs
   
(2,726
)
   
(1,247
)
   
(5,044
)
   
(2,049
)
Free cash flow
 
$
(6,819
)
 
$
(4,029
)
 
 $
(16,501
)
 
 $
(6,934
)
 
Off-Balance Sheet Arrangements

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

Recent Accounting Pronouncements

No new accounting standards have been adopted since our Annual Report on Form 10-K for the fiscal year ended December 31, 2010 was filed. We do not believe that any new accounting pronouncements not yet effective will have a material impact on our financial statements once adopted. 
 
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.

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, 2011. 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, 2011, 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, 2011 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

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

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

In addition to the above cases, 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 2010 net revenues in the fourth quarter of 2010, and the net income that we generated during the fourth quarter of 2010 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 2011 capital expenditures will range from 7.0% to 7.5% of 2011 net revenues.  Operational difficulties, such as a significant interruption in the operations of either our Charlotte, North Carolina or Phoenix, Arizona production facilities could delay production or shipment of our products.  Our inability to meet our production requirements could lead to customer dissatisfaction and damage our reputation and 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 2010 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 and may have further negative impact in the future.

Weak economic conditions, low consumer spending and decreased consumption may harm our operating results.  Purchases of our products are often discretionary. If the economic climate does not improve, customers or potential customers could delay, reduce or forego their purchases of our products and services, which could impact our business in a number of ways, including lower prices for our products and services and reduced sales.  In addition, adverse economic conditions may lead to price increases by our suppliers or increase our operating expenses due to, among others, higher costs of labor, energy, equipment and facilities.  A prolonged and slow economic recovery or a renewed recession may also lead to additional restructuring actions and associated expenses.  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 experiences 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;