Attached files

file filename
EXCEL - IDEA: XBRL DOCUMENT - SHUTTERFLY INCFinancial_Report.xls
EX-31.01 - EXHIBIT - SHUTTERFLY INCex31_01q3-14.htm
EX-31.02 - EXHIBIT - SHUTTERFLY INCex31_02q3-14.htm
EX-32.01 - EXHIBIT - SHUTTERFLY INCex32_01q3-14.htm
EX-32.02 - EXHIBIT - SHUTTERFLY INCex32_02q3-14.htm

 
UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, DC 20549
Form 10-Q
(Mark One)
ý
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended September 30, 2014
 
or
o
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from            to
Commission file number 001-33031

SHUTTERFLY, INC.
(Exact Name of Registrant as Specified in Its Charter)
Delaware
 
94-3330068
( State or Other Jurisdiction of Incorporation or Organization)
 
(IRS Employer Identification No.)

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

Registrant’s Telephone Number, Including Area Code
(650) 610-5200

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

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

Indicate by check mark whether the Registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer 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   x
Accelerated Filer   o
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   ý

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.
Class
 
Outstanding at October 31, 2014
Common stock, $0.0001 par value per share
 
38,748,851
 



TABLE OF CONTENTS

 
Page
Number
Part I - Financial Information
 
Item 1. Financial Statements
 
Part II - Other Information
 
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)
 
 
September 30, 2014
 
December 31, 2013
ASSETS
 
 
 
Current assets:
 
 
 
Cash and cash equivalents
$
197,665

 
$
499,084

Short-term investments
50,906

 

Accounts receivable, net
25,980

 
21,641

Inventories
16,279

 
9,629

Deferred tax asset, current portion
27,666

 
26,942

Prepaid expenses and other current assets
43,694

 
21,260

Total current assets
362,190

 
578,556

Long-term investments
51,739

 

Property and equipment, net
209,322

 
155,727

Intangible assets, net
93,944

 
118,621

Goodwill
396,942

 
397,306

Deferred tax asset, net of current portion
520

 
520

Other assets
14,857

 
15,412

Total assets
$
1,129,514

 
$
1,266,142

LIABILITIES AND STOCKHOLDERS’ EQUITY
 
 
 
Current liabilities:
 
 
 
Accounts payable
$
28,405

 
$
33,656

Accrued liabilities
47,843

 
107,448

Deferred revenue
31,832

 
24,114

Total current liabilities
108,080

 
165,218

Convertible senior notes, net
252,224

 
243,493

Deferred tax liability
28,846

 
42,995

Other liabilities
47,510

 
26,341

Total liabilities
436,660

 
478,047

Commitments and contingencies (Note 9)

 

Stockholders’ equity:
 
 
 
 Common stock, $0.0001 par value; 100,000 shares authorized; 38,533 and 38,196 shares
issued and outstanding on September 30, 2014 and December 31, 2013, respectively
4

 
4

Additional paid-in capital
834,696

 
771,875

Accumulated other comprehensive loss
(32
)
 

Accumulated earnings/(deficit)
(141,814
)
 
16,216

Total stockholders' equity
692,854

 
788,095

Total liabilities and stockholders' equity
$
1,129,514

 
$
1,266,142

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

3


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

 
Three Months Ended
 
Nine Months Ended
 
September 30,
 
September 30,
 
2014
 
2013
 
2014
 
2013
Net revenues
$
142,008

 
$
122,685

 
$
438,255

 
$
372,854

Cost of net revenues
89,726

 
71,308

 
249,404

 
204,877

Gross profit
52,282

 
51,377

 
188,851

 
167,977

Operating expenses:
 

 
 

 
 
 
 
Technology and development
33,488

 
27,508

 
97,102

 
78,032

Sales and marketing
42,082

 
36,774

 
128,695

 
109,946

General and administrative
25,639

 
21,717

 
77,289

 
62,518

Total operating expenses
101,209

 
85,999

 
303,086

 
250,496

Loss from operations
(48,927
)
 
(34,622
)
 
(114,235
)
 
(82,519
)
Interest expense
(4,381
)
 
(3,609
)
 
(12,184
)
 
(5,684
)
Interest and other income, net
102

 
139

 
383

 
181

Loss before income taxes
(53,206
)
 
(38,092
)
 
(126,036
)
 
(88,022
)
Benefit from income taxes
6,962

 
27,944

 
18,526

 
53,658

Net loss
$
(46,244
)
 
$
(10,148
)
 
$
(107,510
)
 
$
(34,364
)
 
 
 
 
 
 
 
 
Net loss per share - basic and diluted
$
(1.20
)
 
$
(0.27
)
 
$
(2.79
)
 
$
(0.92
)
 
 
 
 
 
 
 
 
Weighted-average shares outstanding - basic and diluted
38,453

 
37,814

 
38,470

 
37,541

 
 
 
 
 
 
 
 
Stock-based compensation is allocated as follows:
 
 
 

 
 
 
 
Cost of net revenues
$
886

 
$
646

 
$
2,782

 
$
1,802

Technology and development
1,320

 
2,459

 
6,196

 
6,843

Sales and marketing
5,591

 
5,774

 
16,837

 
14,030

General and administrative
5,991

 
5,103

 
18,679

 
15,494


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

4


SHUTTERFLY, INC.
CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
(In thousands)
(Unaudited)
 
Three Months Ended
 
Nine Months Ended
 
September 30,
 
September 30,
 
2014
 
2013
 
2014
 
2013
Net loss
$
(46,244
)
 
$
(10,148
)
 
$
(107,510
)
 
$
(34,364
)
Other comprehensive loss, net of reclassification adjustments:
 
 
 
 
 
 
 
Unrealized losses on investments, net
(35
)
 

 
(53
)
 

Tax benefit on unrealized losses on investments, net
14

 

 
21

 

Other comprehensive loss, net of tax
(21
)
 

 
(32
)
 

Comprehensive loss
$
(46,265
)
 
$
(10,148
)
 
$
(107,542
)
 
$
(34,364
)

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


5


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

 
Nine Months Ended
 
September 30,
 
2014
 
2013
Cash flows from operating activities:
 
 
 
Net loss
$
(107,510
)
 
$
(34,364
)
Adjustments to reconcile net loss to net cash used in operating activities:
 

 
 

Depreciation and amortization
46,079

 
30,652

Amortization of intangible assets
25,853

 
22,239

Amortization of debt discount and debt issuance costs
9,610

 
4,592

Stock-based compensation, net of forfeitures
44,494

 
38,169

Loss on disposal of property and equipment and rental assets
51

 
10

Deferred income taxes
(14,852
)
 
(7,988
)
Tax benefit from stock-based compensation
13,713

 
4,745

Excess tax benefits from stock-based compensation
(14,102
)
 
(5,385
)
Changes in operating assets and liabilities:
 

 
 

Accounts receivable, net
(4,338
)
 
(1,455
)
Inventories
(6,650
)
 
(2,426
)
Prepaid expenses and other current assets
(22,064
)
 
(53,774
)
Other assets
(2,391
)
 
(7,427
)
Accounts payable
(5,710
)
 
(10,670
)
Accrued and other liabilities
(62,447
)
 
(50,735
)
Deferred revenue
7,719

 
2,188

Other non-current liabilities
(496
)
 
357

Net cash used in operating activities
(93,041
)
 
(71,272
)
Cash flows from investing activities:
 

 
 

Acquisition of business and intangible assets, net of cash acquired

 
(41,120
)
Purchases of property and equipment
(56,872
)
 
(48,550
)
Capitalization of software and website development costs
(15,539
)
 
(12,057
)
Purchases of investments
(117,329
)
 

Maturities and sales of investments
15,520

 

Proceeds from sale of property and equipment and rental assets
743

 
173

Net cash used in investing activities
(173,477
)
 
(101,554
)
Cash flows from financing activities:
 

 
 

Proceeds from borrowings on convertible senior notes, net of issuance costs

 
291,897

Proceeds from issuance of warrants

 
43,560

Purchase of convertible note hedge

 
(63,510
)
Proceeds from issuance of common stock upon exercise of stock options
3,058

 
18,275

Repurchases of common stock
(50,520
)
 
(32,241
)
Excess tax benefits from stock-based compensation
14,102

 
5,385

Principal payments of capital lease and financing obligations
(1,541
)
 
(488
)
Net cash provided by / (used in) financing activities
(34,901
)
 
262,878

Net increase / (decrease) in cash and cash equivalents
(301,419
)
 
90,052

Cash and cash equivalents, beginning of period
499,084

 
245,088

Cash and cash equivalents, end of period
$
197,665

 
$
335,140

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

6



 
Nine Months Ended
 
September 30,
 
2014
 
2013
Supplemental schedule of non-cash activities
 

 
 

Net increase / (decrease) in accrued purchases of property and equipment
$
1,050

 
$
(1,506
)
Net increase in accrued capitalized software and website development costs
981

 

Increase in estimated fair market value of buildings under build-to-suit leases
17,575

 
4,552

Amount due from adjustment of net working capital from acquired business
253

 
73

Property and equipment acquired under capital leases
6,831

 


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

7


SHUTTERFLY, INC.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

Note 1 — The Company and Summary of Significant Accounting Policies

Shutterfly, Inc., (the “Company” or “Shutterfly”) was incorporated in the state of Delaware in 1999 and began its services in December 1999. The Company is the leading manufacturer and digital retailer of high-quality personalized products and services offered through a family of lifestyle brands. The Company provides customers a full range of products and services to organize and archive digital images; share pictures; order prints and create an assortment of personalized items such as photo books, greeting cards and stationery and calendars. Shutterfly also operates a premier online marketplace for high-quality photographic and video equipment rentals. The Company also provides enterprise services; printing and shipping of direct marketing and other variable data print products and formats. 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 condition as of the date of the interim balance sheet have been included. Operating results for the three and nine months ended September 30, 2014 are not necessarily indicative of the results that may be expected for the year ending December 31, 2014, or for any other period.

The December 31, 2013 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, 2013 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.

Investments

Investments, which may include agency bonds, corporate debt securities, and U.S. government securities, are classified as available-for-sale and are reported at fair value using the specific identification method. Unrealized gains and losses are excluded from earnings and reported as a component of other comprehensive income (loss), net of related estimated tax provisions or benefits. Investments whose maturity dates are less than twelve months are classified as short-term, and those with maturity dates greater than twelve months are classified as long-term.

The Company assesses whether an other-than-temporary impairment loss on its investments has occurred due to declines in fair value or other market conditions. With respect to the Company's debt securities, this assessment takes into account the severity and duration of the decline in value, its intent to sell the security, whether it is more likely than not that it will be required to sell the security before recovery of its amortized cost basis, and whether it expects to recover the entire amortized cost basis of the

8

SHUTTERFLY, INC.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

security (that is, whether a credit loss exists). The Company did not recognize an other-than-temporary impairment loss on its investments in the three and nine months ended September 30, 2014.

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 from future taxable income. The Company's determination of its valuation allowance is based upon a number of assumptions, judgments, and estimates, including forecasted earnings, future taxable income, and the relative proportions of revenue and income before taxes in each jurisdiction.
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 income.
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 September 30, 2014 and December 31, 2013.

The Company is subject to taxation in jurisdictions within the United States and Israel.

Segment Reporting

The Company reports as one operating segment with the Chief Executive Officer (“CEO”) acting as the Company’s chief operating decision maker. The Company’s CEO reviews financial information presented on a consolidated basis for purposes of allocating resources and evaluating financial performance. The Company has a single reporting unit and there are no segment managers who are held accountable for operations, operating results, or components below the consolidated unit level.

Net revenues by Consumer and Enterprise categories were as follows:
 
 
Three Months Ended September 30,
 
Nine Months Ended September 30,
 
 
2014
 
2013
 
2014
 
2013
 
 
(in thousands)
Net revenues
 
 
 
 
 
 
 
 
Consumer
 
$
127,299

 
$
112,695

 
$
408,073

 
$
347,395

Enterprise
 
14,709

 
9,990

 
30,182

 
25,459

Total net revenues
 
$
142,008

 
$
122,685

 
$
438,255

 
$
372,854


Recent Accounting Pronouncements

No new accounting standards have been adopted since the Company filed its Annual Report on Form 10-K for the fiscal year ended December 31, 2013.

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

9

SHUTTERFLY, INC.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

January 1, 2017 and can be applied either retrospectively to each period presented or as a cumulative-effect adjustment as of the date of adoption. The Company is evaluating the impact of adopting this new accounting standard on its financial statements.

In August 2014, the FASB issued new guidance related to the disclosures around going concern. The new standard provides guidance around management's responsibility to evaluate whether there is substantial doubt about an entity's ability to continue as a going concern and to provide related footnote disclosures. The new standard is effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2016. Early adoption is permitted. The adoption of this standard is not expected to have a material impact on the Company's financial statements.

Note 2 — Stock-Based Compensation

Stock Option Activity

A summary of the Company’s stock option activity for the three and nine months ended September 30, 2014 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, 2013
616

 
$
23.10

 
 
 
 
Granted

 

 
 
 
 
Exercised
(77
)
 
17.64

 
 
 
 
Forfeited, cancelled or expired
(9
)
 
31.88

 
 
 
 
Balances, March 31, 2014
530

 
$
23.75

 
5.2
 
$
10,620

Granted

 

 
 
 
 
Exercised
(7
)
 
18.84

 
 
 
 
Forfeited, cancelled or expired
(7
)
 
26.84

 
 
 
 
Balances, June 30, 2014
516

 
$
23.78

 
5.0
 
$
10,505

Granted

 

 
 
 
 
Exercised
(96
)
 
16.38

 
 
 
 
Forfeited, cancelled or expired
(1
)
 
32.10

 
 
 
 
Balances, September 30, 2014
419

 
$
25.44

 
4.9
 
$
9,930

Options vested and expected to vest at September 30, 2014
415

 
$
25.38

 
4.9
 
$
9,861

Options vested at September 30, 2014
351

 
$
23.75

 
4.4
 
$
8,913

 
During the three and nine months ended September 30, 2014, the Company did not grant any options. The total intrinsic value of options exercised during the three months ended September 30, 2014 was $3.2 million.  Net cash proceeds from the exercise of stock options were $1.6 million and $3.1 million for the three and nine months ended September 30, 2014, respectively.

Restricted Stock Units

The Company grants restricted stock units (“RSUs”) to its employees under the provisions of the 2006 Plan and inducement awards to certain new employees upon hire in accordance with NASDAQ Listing Rule 5635(c)(4). The cost of RSUs is determined using the fair value of the Company’s common stock on the date of grant. RSUs typically vest and are settled annually, based on a three or four year total vesting term. Compensation cost associated with RSUs is amortized on a straight-line basis over the requisite service period.


10

SHUTTERFLY, INC.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

Restricted Stock Unit Activity

A summary of the Company’s RSU activity for the three and nine months ended September 30, 2014, is as follows (share numbers in thousands):
 
Number of
Units
Outstanding
 
Weighted
Average
Grant Date
Fair Value
Awarded and unvested, December 31, 2013
3,862

 
$
38.59

Granted
975

 
47.39

Vested
(897
)
 
35.69

Forfeited
(183
)
 
43.11

Awarded and unvested, March 31, 2014
3,757

 
$
41.34

Granted
185

 
41.21

Vested
(177
)
 
34.37

Forfeited
(124
)
 
39.88

Awarded and unvested, June 30, 2014
3,641

 
$
41.86

Granted
233

 
48.12

Vested
(125
)
 
38.63

Forfeited
(138
)
 
41.18

Awarded and unvested, September 30, 2014
3,611

 
$
42.40

RSUs expected to vest, September 30, 2014
3,229

 
 

 
Included in the RSU grants for the nine months ended September 30, 2014, are 387,000 RSUs that have both performance criteria tied to the Company’s 2014 financial performance and four year service criteria, as well as grants made to the CEO that vest upon the achievement of multi-year financial performance-based and shareholder return-based goals (“PBRSUs”). 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.

Employee stock-based compensation expense recognized in the three and nine months ended September 30, 2014 and 2013, was calculated based on awards ultimately expected to vest and has been reduced for estimated forfeitures. Forfeitures are estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates.

At September 30, 2014, the Company had $100.5 million of total unrecognized compensation expense, net of estimated forfeitures, related to stock options, RSUs and PBRSUs that will be recognized over a weighted-average period of approximately two years.

Note 3 — Net Loss Per Share

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

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


11

SHUTTERFLY, INC.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

A summary of the net loss per share for the three and nine months ended September 30, 2014 and 2013 is as follows (in thousands, except per share amounts):
 
 
Three Months Ended
 
Nine Months Ended
 
September 30,
 
September 30,
 
2014
 
2013
 
2014
 
2013
Net loss per share:
 
 
 
 
 
 
 
Numerator
 
 
 
 
 
 
 
Net loss
$
(46,244
)
 
$
(10,148
)
 
$
(107,510
)
 
$
(34,364
)
Denominator for basic and diluted net loss per share
 

 
 

 
 
 
 
Weighted-average common shares outstanding
38,453

 
37,814

 
38,470

 
37,541

Net loss per share — basic and diluted
$
(1.20
)
 
$
(0.27
)
 
$
(2.79
)
 
$
(0.92
)

Note 4 — Investments

At September 30, 2014, the estimated fair value of short-term and long-term investments classified as available for sale are as follows (in thousands):
 
 
September 30, 2014
 
 
Amortized Cost
 
Gross Unrealized Gains
 
Gross Unrealized Losses
 
Estimated Fair Value
Short-term investments
 
 
 
 
 
 
 
 
Corporate debt securities
 
$
50,914

 
$
9

 
$
(17
)
 
$
50,906

Agency securities
 

 

 

 

Total short-term investments
 
$
50,914

 
$
9

 
$
(17
)
 
$
50,906

Long-term investments
 
 
 
 
 
 
 
 
Corporate debt securities
 
$
31,016

 
$
5

 
$
(35
)
 
$
30,986

Agency securities
 
18,970

 

 
(15
)
 
18,955

US Government securities
 
1,798

 

 

 
1,798

Total long-term investments
 
$
51,784

 
$
5

 
$
(50
)
 
$
51,739


The Company had no short-term or long-term investments that have been in a continuous unrealized loss position for more than 12 months as of September 30, 2014 and no impairments were recorded in the period. The Company had no material realized gains or losses during the nine months ended September 30, 2014.

The following table summarizes the contractual maturities of the Company's investments as of September 30, 2014 (in thousands):
 
September 30, 2014
One year or less
$
50,906

One year through three years
51,739

 
$
102,645


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

12

SHUTTERFLY, INC.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

Note 5 — Fair Value Measurement

Cash Equivalents and Investments

The Company measures the fair value of money market funds and investments based on quoted prices in active markets for identical assets or liabilities. All other financial instruments were valued either based on recent trades of securities in inactive markets or based on quoted market prices of similar instruments and other significant inputs derived from or corroborated by observable market data. The Company did not hold any cash equivalents or investments categorized as Level 3 as of September 30, 2014.

The following table summarizes, by major security type, the Company's cash equivalents and investments that are measured at fair value on a recurring basis and are categorized using the fair value hierarchy (in thousands):
 
Total Estimated Fair Value as of
 
September 30, 2014
 
December 31, 2013
Level 1 Securities:
 
 
 
Money market funds
$
11,589

 
$

Level 2 Securities:
 
 
 
Agency securities
18,955

 

Corporate debt securities
81,892

 

US Government securities
1,798

 

Total cash equivalents and investments
$
114,234

 
$


The Company did not have any money market funds or investments as of December 31, 2013.

Convertible Senior Notes

As of September 30, 2014, the fair value of the convertible senior notes, which was determined based on inputs that are observable in the market or that could be derived from, or corroborated with, observable market data, including our stock price, interest rates and credit spread (Level 2) were as follows (in thousands):
 
Total Estimated Fair Value as of
 
September 30, 2014
 
December 31, 2013
Convertible senior notes
$
287,667

 
$
237,066


Note 6 — Balance Sheet Components

Prepaid Expenses and Other Current Assets
 
September 30,
2014
 
December 31,
2013
 
(in thousands)
Intra-period deferred tax asset
$
17,387

 
$

Deferred costs
6,558

 
4,915

Prepaid service contracts – current portion
6,334

 
5,044

Other prepaid expenses and current assets
13,415

 
11,301

 
$
43,694

 
$
21,260


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


13

SHUTTERFLY, INC.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

Other Assets
 
September 30,
2014
 
December 31,
2013
 
(in thousands)
Other assets
$
14,857

 
$
15,412


Other assets includes the long-term portion of intellectual property prepaid royalties, the long-term portion of issuance costs related to the Company's 0.25% Convertible Notes, the long-term portion of prepaid service contracts, and deposits on long-term leases and other contracts.

Property and Equipment, Net
 
September 30,
2014
 
December 31,
2013
 
(in thousands)
Computer and other equipment
$
182,828

 
$
182,491

Software
22,099

 
19,719

Leasehold improvements
54,427

 
17,702

Buildings under build-to-suit leases
34,027

 
16,452

Rental equipment
10,588

 
11,943

Furniture and fixtures
14,697

 
8,391

Capitalized software and website development costs
84,014

 
66,196

 
402,680

 
322,894

Less: Accumulated depreciation and amortization
(193,358
)
 
(167,167
)
Net property and equipment
$
209,322

 
$
155,727

 
Building value of $34.0 million under build-to-suit leases represents the estimated fair market value of buildings under build-to-suit leases of which the Company is the "deemed owner" for accounting purposes only. See Note 9 - Commitments and Contingencies for further discussion of the Company's build-to-suit leases.

Included within Computer and other equipment is approximately $13.8 million of capital lease obligations for various pieces of manufacturing facility and computer equipment. Accumulated depreciation of assets under capital lease totaled $2.0 million at September 30, 2014.

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

Depreciation and amortization expense totaled $16.9 million and $11.4 million for the three months ended September 30, 2014 and 2013, respectively. Depreciation and amortization expense totaled $46.1 million and $30.7 million for the nine months ended September 30, 2014 and 2013, respectively.


14

SHUTTERFLY, INC.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

Accrued Liabilities
 
September 30,
2014
 
December 31,
2013
 
(in thousands)
Accrued compensation
$
12,898

 
$
14,872

Accrued production costs
8,500

 
34,525

Accrued marketing expenses
8,251

 
26,203

Accrued consulting
4,348

 
4,548

Accrued purchases
4,097

 
3,723

Accrued income and sales taxes
3,193

 
16,465

Capital lease obligations
2,766

 
1,530

Accrued other
3,790

 
5,582

 
$
47,843

 
$
107,448

 
Other Liabilities
 
September 30,
2014
 
December 31,
2013
 
(in thousands)
Other liabilities
$
47,510

 
$
26,341


Other liabilities includes the long-term portion of capital lease obligations, deferred rent, and financing obligations related to the Company's build-to-suit leases.

Note 7 — Convertible Senior Notes

0.25% Convertible Senior Notes Due May 15, 2018
In May 2013, the Company issued $300.0 million aggregate principal amount of 0.25% convertible senior notes (the "Notes") due May 15, 2018, unless earlier purchased by the Company or converted. Interest is payable semiannually in arrears on May 15 and November 15 of each year, commencing on November 15, 2013.
The Notes are governed by an Indenture between the Company, as issuer, and Wells Fargo Bank, National Association, as trustee. The Notes are unsecured and rank senior in right of payment to the Company's future indebtedness that is expressly subordinated in right of payment to the Notes and rank equal in right of payment to the Company's existing and future liabilities that are not so subordinated and are effectively subordinated in right of payment to any of the Company's cash equal to the principal amount of the Notes, and secured indebtedness to the extent of the value of the assets securing such indebtedness and are structurally subordinated to all existing and future indebtedness and liabilities incurred by the Company's subsidiaries.
Upon conversion, the Company will pay or deliver, as the case may be, cash, shares of the Company's common stock or a combination of cash and shares of common stock, at the Company's election.
The initial conversion rate is 15.5847 shares of common stock per $1,000 principal amount of Notes. The initial conversion price is $64.17 per share of common stock. Throughout the term of the Notes, the conversion rate may be adjusted upon the occurrence of certain events. Holders of the Notes will not receive any cash payment representing accrued and unpaid interest upon conversion of a Note. Accrued but unpaid interest will be deemed to be paid in full upon conversion rather than cancelled, extinguished or forfeited. Holders may convert their Notes only under the following circumstances:

during any calendar quarter commencing after the calendar quarter ending on September 30, 2013 (and only during such calendar quarter), if the last reported sale price of the Company's common stock for at least 20 trading days (whether or not consecutive) during a period of 30 consecutive trading days ending on the last trading day of the immediately preceding calendar quarter is greater than or equal to 130% of the conversion price on each applicable trading day;
during the five business day period after any ten consecutive trading day period (the “Notes Measurement Period”) in which the "trading price" (as the term is defined in the Indenture) per $1,000 principal amount of notes for each

15

SHUTTERFLY, INC.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

trading day of such Notes Measurement Period was less than 98% of the product of the last reported sale price of the Company's common stock on such trading day and the conversion rate on each such trading day;
upon the occurrence of specified corporate events; or
at any time on or after December 15, 2017 until the close of business on the second scheduled trading immediately preceding the maturity date.
As of September 30, 2014, the Notes are not yet convertible.
In accounting for the issuance of the Notes, the Company separated the Notes into liability and equity components. The carrying amount of the liability component was calculated by measuring the fair value of a similar liability that does not have an associated convertible feature. The carrying amount of the equity component representing the conversion option was determined by deducting the fair value of the liability component from the face value of the Notes as a whole. The excess of the principal amount of the liability component over its carrying amount (“debt discount”) is amortized to interest expense over the term of the Notes. The equity component is not remeasured as long as it continues to meet the conditions for equity classification.
In accounting for the transaction costs related to the Note issuance, the Company allocated the total amount incurred to the liability and equity components based on their relative values. Issuance costs attributable to the liability component, totaling $6.4 million, are being amortized to expense over the term of the Notes, and issuance costs attributable to the equity component, totaling $1.7 million, were netted with the equity component in stockholders' equity. Additionally, the Company recorded a deferred tax asset of $0.6 million on a portion of the equity component transaction costs which are deductible for tax purposes.
Concurrently with the Note issuance, the Company repurchased 0.6 million shares of common stock for approximately $30.0 million.
The Notes consist of the following (in thousands):
 
 
September 30, 2014
 
December 31, 2013
Liability component:
 
 
 
 
Principal
 
$
300,000

 
$
300,000

Less: debt discount, net of amortization
 
(47,776
)
 
(56,507
)
Net carrying amount
 
$
252,224

 
$
243,493

 
 
 
 
 
Equity component (1)
 
$
63,510

 
$
63,510

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

The following table sets forth total interest expense recognized related to the Notes (in thousands):
 
 
Three Months Ended September 30,
 
Nine Months Ended September 30,
 
 
2014
 
2013
 
2014
 
2013
0.25% coupon
 
$
187

 
$
188

 
$
562

 
$
281

Amortization of debt issuance costs
 
297

 
260

 
878

 
420

Amortization of debt discount
 
2,951

 
2,771

 
8,732

 
4,172

 
 
$
3,435

 
$
3,219

 
$
10,172

 
$
4,873

 
Note Hedge
To minimize the impact of potential economic dilution upon conversion of the Notes, the Company entered into convertible note hedge transactions with respect to its common stock (the “Note Hedge”). In May 2013, the Company paid an aggregate amount of $63.5 million for the Note Hedge. The Note Hedge will expire upon maturity of the Notes. The Note Hedge is intended to offset the potential dilution upon conversion of the Notes and/or offset any cash payments the Company is required to make in excess of the principal amount upon conversion of the Notes in the event that the market value per share of the Company's common stock, as measured under the Notes, is greater than the strike price of the Note Hedge, which initially corresponds to the conversion price of the Notes and is subject to anti-dilution adjustments substantially similar to those applicable to the conversion rate of the Notes.

16

SHUTTERFLY, INC.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

Warrant
Separately, in May 2013, the Company entered into warrant transactions (the “Warrant”), whereby the Company sold warrants to acquire shares of the Company's common stock at a strike price of $83.18 per share. The Company received aggregate proceeds of $43.6 million from the sale of the Warrant. If the average market value per share of the Company's common stock for the reporting period, as measured under the Warrant, exceeds the strike price of the Warrant, the Warrant will have a dilutive effect on the Company's earnings per share. The Warrant is a separate transaction, entered into by the Company and is not part of the Notes or the Note Hedge, and has been accounted for as part of additional paid-in capital. Holders of the Notes and Note Hedge will not have any rights with respect to the Warrant.

Note 8 — Share Repurchase Program

On October 24, 2012, the Company's Board of Directors conditionally authorized and the Audit Committee subsequently approved a share repurchase program for up to $60.0 million of the Company's common stock. On February 6, 2014, the Company's Board of Directors approved an increase to the program, authorizing the Company to repurchase up to $100.0 million of the Company's common stock in addition to any amounts repurchased as of that date. The share repurchase program is subject to prevailing market conditions and other considerations; does not require Shutterfly to repurchase any dollar amount or number of shares; and may be suspended or discontinued at any time. The share repurchase authorization, which was effective immediately, permits the Company to effect repurchases for cash from time to time through open market, privately negotiated or other transactions, including pursuant to trading plans established in accordance with Rules 10b5-1 and 10b-18 of the Securities Exchange Act of 1934, as amended, or by a combination of such methods.
In the nine months ended September 30, 2014, the Company repurchased 1,041,638 shares of its outstanding common stock at an average price of $48.50 per share for a total of $50.5 million.
In 2013, the Company repurchased 70,313 shares of its outstanding common stock at an average price of $31.87 per share for a total of $2.2 million.

All repurchased shares of common stock have been retired.

Note 9 — Commitments and Contingencies

Build-to-Suit Leases

During the year ended December 31, 2013, the Company executed a lease for a new 217,000 square foot production facility in Shakopee, Minnesota. This facility will provide additional production capacity. Both the landlord and the Company will incur costs to construct the facility according to the Company's operating specifications, and as a result, the Company has concluded that it is the “deemed owner” of the building (for accounting purposes only) during the construction period. During the nine months ended September 30, 2014 and the year ended December 31, 2013, the landlord incurred $13.8 million and $7.0 million of building construction costs, including capitalized interest, which the Company has recorded as an asset, with a corresponding construction financing obligation, as a component of other non-current liabilities. The Company will increase the asset and financing obligation as additional building uplift costs are incurred by the landlord during the construction period.

Upon completion of construction of the facility in Shakopee, Minnesota in the second quarter of 2014, the Company evaluated the de-recognition of the asset and liability under the provisions for sale-leaseback transactions. The Company concluded that it had forms of continued economic involvement in the facility, and therefore did not comply with the provisions for sale-leaseback accounting.  Instead, the lease will be accounted for as a financing obligation and lease payments will be attributed to (1) a reduction of the principal financing obligation; (2) imputed interest expense; and (3) land lease expense (which is considered an operating lease and a component of cost of goods sold) representing an imputed cost to lease the underlying land of the facility. In addition, the underlying building asset will be depreciated over the building's estimated useful life of 30 years. At the conclusion of the lease term, the Company would de-recognize both the net book values of the asset and financing obligation.

Also during the year ended December 31, 2013, the Company executed a lease for a new 217,000 square foot production facility in Tempe, Arizona. This facility will consolidate all of the Company's locations in the greater Phoenix area, including the recently acquired R&R Images facility, as well as offer flexibility for future expansion, and is expected to become operational during 2015. Both the landlord and the Company will incur costs to construct the facility according to the Company's operating

17

SHUTTERFLY, INC.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

specifications, and as a result, the Company has concluded that it is the “deemed owner” of the building (for accounting purposes only) during the construction period. In April 2014, the lease agreement was amended to increase the square footage of the facility from 217,000 square feet to 237,000 square feet. During the nine months ended September 30, 2014, the landlord incurred $3.8 million of building construction costs which the Company has recorded as an asset, with a corresponding construction financing obligation, as a component of other non-current liabilities. The Company will increase the asset and financing obligation as additional building uplift costs are incurred by the landlord during the construction period. Upon completion of the construction of the facility in Tempe, Arizona, the Company will evaluate the de-recognition of the asset and liability under the provisions of ASC 840.40 Leases - Sale-Leaseback Transactions.

Indemnifications

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

Contingencies

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

Syndicated Credit Facility

On November 22, 2011, the Company entered into a credit agreement (“Credit Agreement”) with J.P. Morgan Securities LLC, Wells Fargo Securities, LLC, Fifth Third Bank, Silicon Valley Bank, US Bank and Citibank, N.A. (“the Banks”). JPMorgan Chase Bank, N.A. acted as administrative agent in the Credit Agreement. The Credit Agreement is for five years and provides for a $125.0 million senior secured revolving credit facility (the “credit facility”) and if requested by the Company, the Banks may increase the credit facility by $75.0 million subject to certain conditions. In December 2013, the Company requested and received the entire incremental amount for a total credit facility of $200.0 million. As part of the expansion, Bank of America, N.A. and Morgan Stanley Bank, N.A. joined the syndicate. From inception through September 30, 2014, the Company has not drawn on the credit facility.

At the Company’s option, loans under the Facility will bear stated interest based on the Base Rate or Adjusted LIBO Rate, in each case plus the Applicable Rate (respectively, as defined in the Credit Agreement). The Base Rate will be, for any day, the highest of (a) 1/2 of 1% per annum above the Federal Funds Effective Rate (as defined in the Credit Agreement), (b) JPMorgan Chase Bank’s prime rate and (c) the Adjusted LIBO Rate for a term of one month plus 1.00%. Eurodollar borrowings may be for one, two, three or six months (or such period that is 12 months or less, requested by Intersil and consented to by all the Lenders) and will be at an annual rate equal to the period-applicable Eurodollar Rate plus the Applicable Rate. The Applicable Rate for all revolving loans is based on a pricing grid ranging from 0.05% to 1.25% per annum for Base Rate loans and 1.50% to 2.25% for Adjusted LIBO Rate loans based on the Company’s Leverage Ratio (as defined in the Credit Agreement).

On May 10, 2013, the Company amended the Credit Agreement by and among the Company and the Banks to (i) permit the issuance of the Notes and the related Note Hedge and Warrant, (ii) amend certain of the restrictive covenants set forth in the Credit Agreement, (iii) increase the Leverage Ratio (as defined the Credit Agreement) to be maintained by the Company to be at or below 3.50 to 1.00, and (iv) add a covenant requiring that the Company not permit its Senior Secured Leverage Ratio (as defined in the Credit Agreement) to exceed 1.60 to 1.00. Unchanged from the initial credit agreement, the Credit Agreement contains customary representations and warranties, affirmative and negative covenants, and events of default. Also, the Company may not permit the ratio of its Consolidated EBITDA for any period of four consecutive fiscal quarters to its interest and rental expense and the amount of scheduled principal payments on long-term debt, for the same period, to be less than 2.50 to 1.00. As of September 30, 2014, the Company is in compliance with these covenants.

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


18

SHUTTERFLY, INC.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

Legal Matters

The Company is involved in a number of judicial and administrative proceedings that are incidental to its business. Although adverse decisions (or settlements) may occur in one or more of these cases, it is not possible to estimate the possible loss or losses from each of these cases. The final resolution of these lawsuits, individually or in the aggregate, is not expected to have a material adverse effect on the Company's business, financial position or results of operations.

For all cases, at each reporting period, the Company evaluates whether or not a potential loss amount or a potential range of loss is probable and reasonably estimable under the provisions of the authoritative guidance that addresses accounting for contingencies. In such cases, the Company accrues for the amount, or if a range, the Company accrues the low end of the range as a component of legal expense. The Company monitors developments in these legal matters that could affect the estimate the Company had previously accrued. There are no amounts accrued which the Company believes would be material to its financial position and results of operations.


19


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

CAUTIONARY NOTE REGARDING FORWARD-LOOKING STATEMENTS

This report, including the following Management’s Discussion and Analysis of Financial Condition and Results of Operations, contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934 that are based upon our current expectations. These forward-looking statements include statements related to our business strategy and plans, the seasonality of and growth of our business, the impact on us of general economic conditions, trends in key metrics such as total number of customers, total number of orders, and average order value, our capital expenditures for 2014, the sufficiency of our cash and cash equivalents and cash generated from operations for the next 12 months, our operating expenses remaining a consistent percentage of our net revenues, our manufacturing capabilities, effective tax rates, outstanding convertible senior notes, stock repurchase program as well as other statements regarding our future operations, financial condition and prospects and business strategies. In some cases, you can identify forward-looking statements by terminology such as “believe,” “anticipate,” “expect,” “estimate,” “intend,” “seek,” “continue,” “should,” “would,” “could,” “will,” or “may,” or the negative of these terms or other comparable terminology. Forward-looking statements involve risks and uncertainties. Our actual results and the timing of events could differ materially from those anticipated in our forward-looking statements as a result of many factors, including but not limited to, economic downturns and the general state of the economy; changes in consumer discretionary spending as a result of the macroeconomic environment; competition, which could lead to pricing pressure; our ability to expand our customer base, increase sales to existing customers and meet production requirements; our ability to retain and hire necessary employees, including seasonal personnel, and appropriately staff our operations; the impact of seasonality on our business; our ability to develop innovative, new products and services on a timely and cost-effective basis, as well as consumer acceptance of our products, features and services; our ability to successfully acquire businesses and technologies and to successfully integrate and operate these acquired businesses and technologies; our ability to achieve and maintain expected benefits of our partnerships; our ability to develop additional adjacent lines of business; unforeseen changes in expense levels; and our ability to timely upgrade and develop our infrastructure and facilities and the other risks set forth below under “Risk Factors” in Part II, Item 1A of this report. Given these risks and uncertainties, readers are cautioned not to place undue reliance on such forward-looking statements. We assume no obligation to update any of the forward-looking statements after the date of this report or to compare these forward-looking statements to actual results.

Overview
 
We are the leading manufacturer and digital retailer of high-quality personalized products and services offered through a family of lifestyle brands. 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 through our seven trusted premium lifestyle brands: Shutterfly, Tiny Prints, Wedding Paper Divas, Treat, ThisLife, MyPublisher and BorrowLenses.

We 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 Fort Mill, South Carolina, Phoenix, Arizona, Shakopee, Minnesota, and Elmsford, New York 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 total net revenues during our fiscal fourth quarter. Our operations and financial performance depend on general economic conditions in the United States, consumer sentiment and the levels of consumer discretionary spending. We closely monitor these economic measures as their trends are indicators of the health of the overall economy and are some of the key external factors that impact our business.

During the third quarter of 2014, we received bids by several outside parties to acquire the Company. With the help of outside legal and financial advisors, the Board of Directors undertook a deliberate and thoughtful evaluation of all aspects of the various offers. Based upon this review, the Board of Directors unanimously concluded that it was in the best interest of all stakeholders

20


to remain independent at this time. The Board will continue to exercise its fiduciary responsibility to shareholders and will evaluate all credible offers and strategic alternatives with a goal of maximizing long-term shareholder value.

Basis of Presentation

Net Revenues.      Our net revenues are comprised of sales generated from our Consumer and Enterprise categories.

Consumer. Our Consumer revenues include sales from all of our brands and are derived from the sale of photo-based products, such as photo books, stationery and greeting cards, other photo-based merchandise, photo prints, and the related shipping revenues as well as rental revenue from our BorrowLenses brand. Included in our photo-based merchandise are items such as mugs, iPhone cases, mouse pads, desktop plaques and puzzles. Photo prints consist of wallet, 4x6, 5x7, 8x10, and large format sizes. Revenue from advertising displayed on our websites is also included in Consumer revenues.

Enterprise. Our Enterprise revenues are primarily from variable, four-color direct marketing collateral manufactured and fulfilled for business customers.  We continue to focus our efforts on expanding our presence in the Enterprise market.

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

Total Customers.     We closely monitor total customers as a key indicator of demand. Total customers represents the number of transacting customers in a given period. We seek to expand our customer base by empowering our existing customers with sharing and collaboration services, and by conducting integrated marketing and advertising programs. We also acquire new customers through customer list acquisitions. Total customers have increased on an annual basis for each year since inception and we expect this trend to continue.

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

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

Cost of Net Revenues.      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 the facilities where we are the deemed owner (for accounting purposes only) of the building, 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.


21


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

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

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

Interest Expense.      Interest expense consists of interest on our convertible senior notes arising from amortization of debt discount, amortization of debt issuance costs, and our 0.25% coupon payment; costs associated with our five-year syndicated credit facility that became effective in November 2011, as amended in May and December 2013; and costs associated with our capital leases and build-to-suit lease financing obligations.

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

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

Critical Accounting Policies and Estimates

The discussion and analysis of our financial condition and results of operations are based upon our unaudited condensed consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses. On an on-going basis, we evaluate our critical accounting policies and estimates. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. Our critical accounting policies and estimates are discussed in our Annual Report on Form 10-K for the fiscal year ended December 31, 2013.



22


Results of Operations

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

 
Three Months Ended
 
Nine Months Ended
 
September 30,
 
September 30,
 
2014
 
2013
 
2014
 
2013
Net revenues
100
 %
 
100
 %
 
100
 %
 
100
 %
Cost of net revenues
63
 %
 
58
 %
 
57
 %
 
55
 %
Gross profit
37
 %
 
42
 %
 
43
 %
 
45
 %
Operating expenses:
 

 
 

 
 
 
 
Technology and development
24
 %
 
22
 %
 
22
 %
 
21
 %
Sales and marketing
30
 %
 
30
 %
 
29
 %
 
29
 %
General and administrative
18
 %
 
18
 %
 
18
 %
 
17
 %
Total operating expenses
72
 %
 
70
 %
 
69
 %
 
67
 %
Loss from operations
(35
)%
 
(28
)%
 
(26
)%
 
(22
)%
Interest expense
(3
)%
 
(3
)%
 
(3
)%
 
(2
)%
Interest and other income, net
 %
 
 %
 
 %
 
 %
Loss before income taxes
(38
)%
 
(31
)%
 
(29
)%
 
(24
)%
Benefit from income taxes
5
 %
 
23
 %
 
4
 %
 
14
 %
Net loss
(33
)%
 
(8
)%
 
(25
)%
 
(10
)%

Comparison of the Three Month Periods Ended September 30, 2014 and 2013

 
Three Months Ended September 30,
 
2014

2013

$ Change

% Change
 
(in thousands)
Net revenues
 
 
 
 
 
 
 
Consumer
$
127,299

 
$
112,695

 
$
14,604

 
13
%
Enterprise
14,709

 
9,990

 
4,719

 
47
%
Total net revenues
142,008

 
122,685

 
19,323

 
16
%
Cost of net revenues
89,726

 
71,308

 
18,418

 
26
%
Gross profit
$
52,282

 
$
51,377

 
$
905

 
2
%
Percentage of net revenues
37
%
 
42
%
 

 

Key Metrics
 
Customers
2,517

 
2,381

 
136

 
6
%
Orders
4,156

 
3,877

 
279

 
7
%
Average order value
$
30.63

 
$
29.07

 
$
1.56

 
5
%

Net revenues increased $19.3 million, or 16%, for the three months ended September 30, 2014 as compared to the same period in 2013. Consumer net revenues increased $14.6 million, or 13%, in the three months ended September 30, 2014 compared to the same period in 2013.  The increase in Consumer net revenues was primarily a result of increased sales of cards and stationery and photobooks, mobile revenue, and revenue from our BorrowLenses brand which was not included in the three months ended September 30, 2013.  The increase is also reflected in the increases in all of our key metrics in three months ended September 30, 2014, as compared to the same period in 2013, as noted above. Enterprise revenues increased $4.7 million, or 47%, in the three months ended September 30, 2014 compared to the same period in 2013. The increase in enterprise revenue is primarily due to the expansion of projects with existing customers.

Cost of net revenues increased $18.4 million, or 26%, for the three months ended September 30, 2014 as compared to the same period in 2013. As a percentage of net revenues, cost of net revenues increased to 63% in the three months ended September 30, 2014 from 58% in the same period in 2013, which decreased gross margin to 37% in the three months ended September 30, 2014

23


from 42% in the same period in 2013. Overall, the decrease in gross margin percentage from the same period a year ago is largely driven by the start-up expenses of our new Shakopee, Minnesota production facility; increases in our customer service labor and training costs as we have brought employees on-board earlier than the prior year, and a higher mix of enterprise revenues. On a year over year basis, these items reduced our gross profit by approximately $2.0 million.

 
Three Months Ended September 30,
 
2014
 
2013
 
$ Change
 
% Change
 
(in thousands)
Technology and development
$
33,488

 
$
27,508

 
$
5,980

 
22
%
Percentage of net revenues
24
%
 
22
%
 

 

Sales and marketing
$
42,082

 
$
36,774

 
$
5,308

 
14
%
Percentage of net revenues
30
%
 
30
%
 

 

General and administrative
$
25,639

 
$
21,717

 
$
3,922

 
18
%
Percentage of net revenues
18
%
 
18
%
 

 


Our technology and development expense increased $6.0 million, or 22%, for the three months ended September 30, 2014, compared to the same period in 2013. As a percentage of net revenues, technology and development expense increased to 24% in the three months ended September 30, 2014 compared to 22% in the three months ended September 30, 2013. The overall increase was primarily due to an increase of $2.6 million in depreciation expense and an increase of $2.0 million in personnel and related costs due to increased headcount. The increase in technology and development expense was also due to an increase of $1.8 million in professional fees, and an increase of $1.8 million in facility costs primarily from co-location services. These factors were partially offset by an increase of $1.4 million in software and website development costs capitalized and a decrease in stock-based compensation expense of $0.9 million in the current period compared to the same period in the prior year.

At September 30, 2014, headcount in technology and development increased by 13% compared to September 30, 2013, reflecting our strategic focus on increasing the rate of innovation in our product and services offerings, to generate greater differentiation from our competitors, and improve our long-term operating efficiency. In the three months ended September 30, 2014, we capitalized $5.7 million in eligible salary and consultant costs, including $0.7 million of stock-based compensation, associated with software developed or obtained for internal use, compared to $4.3 million capitalized in the three months ended September 30, 2013, which included $0.4 million of stock-based compensation expense.

Our sales and marketing expense increased $5.3 million, or 14%, in the three months ended September 30, 2014 compared to the same period in 2013. As a percentage of net revenues, total sales and marketing expense remained flat at 30% in the three months ended September 30, 2014 and 2013. The increase in sales and marketing expense was primarily due to an increase of $4.0 million related to our integrated marketing campaigns. The increase was also due to the expansion of our internal marketing team which contributed to an increase of $1.2 million in personnel and related costs and an increase of $0.2 million additional intangible asset amortization from acquisitions.This was partially offset by a decrease of $0.2 million in stock-based compensation expense.

Our general and administrative expense increased $3.9 million, or 18%, in the three months ended September 30, 2014 as compared to the same period in 2013. As a percentage of net revenues, general and administrative expense remained flat at 18% for each of the three months ended September 30, 2014 and September 30, 2013. The increase in general and administrative expense was primarily due to an increase of $0.9 million in depreciation and amortization expense, an increase of $0.9 million in stock-based compensation expense, an increase of $0.8 million in personnel related costs as a result of increased headcount, an increase in facility costs of $0.6 million, and an increase in professional fees of $0.5 million. The increase was also attributable to an increase of $0.3 million in credit card fees which was driven by the increase in Consumer net revenues as compared to the prior year. The increase was partially offset by proceeds from intellectual property license agreements of $0.2 million.
 
Three Months Ended September 30,
 
2014
 
2013
 
Change
 
(in thousands)
Interest expense
$
(4,381
)
 
$
(3,609
)
 
$
(772
)
Interest and other income, net
102

 
139

 
(37
)

Interest expense consists of interest on our convertible senior notes, issuance costs associated with our convertible senior notes and credit facility, capital leases and our financing obligation associated with our production facilities in Fort Mill, South

24


Carolina and Shakopee, Minnesota. Interest expense was $4.4 million for the three months ended September 30, 2014 compared to $3.6 million during the same period a year ago.
 
Three Months Ended
September 30,
 
2014
 
2013
 
(in thousands)
Income tax benefit
$
6,962

 
$
27,944

Effective tax rate
13
%
 
73
%

 We recorded an income tax benefit of $7.0 million and $27.9 million for the three months ended September 30, 2014 and 2013, respectively. Our effective tax rate was 13% for the three months ended September 30, 2014, compared to 73% for the three months ended September 30, 2013. Factors that impacted the effective tax rate include the federal domestic production activities deduction, limitations on executive compensation, non-deductible stock-based compensation expense, and disqualifying dispositions of employee incentive stock options.
 
Three Months Ended September 30,
 
2014
 
2013
 
$ Change
 
% Change
 
(in thousands)
Loss before income taxes
$
(53,206
)
 
$
(38,092
)
 
$
(15,114
)
 
40
%
Net loss
(46,244
)
 
(10,148
)
 
(36,096
)
 
356
%
Percentage of net revenues
(33
)%
 
(8
)%
 

 


During the three months ended September 30, 2014, net loss was $46.2 million, an increase of $36.1 million as compared to a net loss of $10.1 million the same period in 2013. As a percentage of net revenues, net loss increased to 33% for the three months ended September 30, 2014 from 8% for the three months ended September 30, 2013.

Comparison of the Nine Month Periods Ended September 30, 2014 and 2013

 
Nine Months Ended September 30,
 
2014
 
2013
 
$ Change
 
% Change
 
(in thousands)
Net revenues
 
 
 
 
 
 
 
Consumer
$
408,073

 
$
347,395

 
$
60,678

 
17
%
Enterprise
30,182

 
25,459

 
4,723

 
19
%
Total net revenues
438,255

 
372,854

 
65,401

 
18
%
Cost of net revenues
249,404

 
204,877

 
44,527

 
22
%
Gross profit
$
188,851

 
$
167,977

 
$
20,874

 
12
%
Percentage of net revenues
43
%
 
45
%
 

 


Net revenues increased $65.4 million, or 18%, for the nine months ended September 30, 2014 as compared to the same period in 2013. Consumer net revenues increased $60.7 million, or 17%, in the nine months ended September 30, 2014 compared to the same period in 2013. The increase in Consumer net revenues was primarily a result of increased sales of photobooks, cards and stationery, photo-based merchandise, and revenue from our MyPublisher and BorrowLenses brands, which was not included in the nine months ended September 30, 2013. Enterprise revenues increased $4.7 million, or 19%, for the nine months ended September 30, 2014 compared to September 30, 2013. The increase in enterprise revenue is primarily due to the expansion of projects with existing customers.

Cost of net revenues increased $44.5 million, or 22%, for the nine months ended September 30, 2014 as compared to the same period in 2013. As a percentage of net revenues, cost of net revenues increased to 57% in the nine months ended September 30, 2014 from 55% in the same period in 2013, which decreased gross margin to 43% in the nine months ended September 30, 2014 from 45% in the same period in 2013. Overall, the increase in cost of net revenues was primarily the result of the increased volume of shipped products, and higher depreciation, increased equipment lease costs, and headcount expenses related to our Fort Mill, South Carolina and Shakopee, Minnesota manufacturing facilities.


25


 
Nine Months Ended September 30,
 
2014
 
2013
 
$ Change
 
% Change
 
(in thousands)
Technology and development
$
97,102

 
$
78,032

 
$
19,070

 
24
%
Percentage of net revenues
22
%
 
21
%
 

 

Sales and marketing
$
128,695

 
$
109,946

 
$
18,749

 
17
%
Percentage of net revenues
29
%
 
29
%
 

 

General and administrative
$
77,289

 
$
62,518

 
$
14,771

 
24
%
Percentage of net revenues
18
%
 
17
%
 

 


Our technology and development expense increased $19.1 million, or 24%, for the nine months ended September 30, 2014, compared to the same period in 2013. As a percentage of net revenues, technology and development expense increased to 22% in the nine months ended September 30, 2014 from 21% in the nine months ended September 30, 2013. The overall increase was primarily due to an increase of $8.2 million in personnel and related costs due to increased headcount. The increase in technology and development expense was also due to an increase of $7.3 million in depreciation expense, an increase of $4.3 million in professional fees, and an increase of $2.9 million in facility costs primarily from co-location services. These factors were partially offset by an increase of $3.9 million in software and website development costs capitalized and a decrease of $0.5 million in stock-based compensation expense in the current period compared to the same period in the prior year.

In the nine months ended September 30, 2014, we capitalized $15.7 million in eligible salary and consultant costs, including $1.5 million of stock-based compensation, associated with software developed or obtained for internal use, compared to $11.8 million capitalized in the nine months ended September 30, 2013, which included $1.3 million of stock-based compensation expense.

Our sales and marketing expense increased $18.7 million, or 17%, in the nine months ended September 30, 2014 compared to the same period in 2013. As a percentage of net revenues, total sales and marketing expense remained flat at 29% for the nine months ended September 30, 2014 and September 30, 2013. The increase was primarily due to an increase of $10.0 million related to our integrated marketing campaigns. The increase in sales and marketing expense was also due to the expansion of our internal marketing team which contributed to an increase of $3.8 million in personnel and related costs and an increase of $2.8 million in stock-based compensation expense . The increase was also attributable to an increase of $1.5 million in intangible asset amortization from acquisition related intangibles, and an increase of $0.5 million in professional fees.

Our general and administrative expense increased $14.8 million, or 24%, in the nine months ended September 30, 2014 as compared to the same period in 2013. As a percentage of net revenues, general and administrative expense increased to 18% in the nine months ended September 30, 2014 from 17% in the nine months ended September 30, 2013. The increase in general and administrative expense was primarily due to an increase of $3.5 million in personnel related costs, an increase of $3.4 million in depreciation and amortization expense, and an increase of $3.2 million in stock-based compensation expense as a result of increased headcount. The increase was also attributable to an increase of $1.8 million in facilities costs and an increase of $1.6 million in credit card fees which was driven by the increase in Consumer net revenues as compared to the prior year, and an increase in professional fees of $1.3 million. This is partially offset by proceeds from intellectual property license agreements of $0.4 million. Also included in general and administrative expense for the nine months ended September 30, 2014 is approximately $1.0 million in fees associated with our evaluation of various inbound offers to acquire the Company.
 
Nine Months Ended September 30,
 
2014
 
2013
 
Change
 
(in thousands)
Interest expense
$
(12,184
)
 
$
(5,684
)
 
$
(6,500
)
Interest and other income, net
383

 
181

 
202


Interest expense consists of interest on our convertible senior notes issued in May 2013, issuance costs associated with our convertible senior notes and credit facility, capital leases and our financing obligation associated with our production facilities in Fort Mill, South Carolina and Shakopee, Minnesota. Interest expense was $12.2 million for the nine months ended September 30, 2014 compared to $5.7 million during the same period a year ago.

26


 
Nine Months Ended
September 30,
 
2014
 
2013
 
(in thousands)
Income tax benefit
$
18,526

 
$
53,658

Effective tax rate
15
%
 
61
%

 We recorded an income tax benefit of $18.5 million and $53.7 million for the nine months ended September 30, 2014 and 2013, respectively. Our effective tax rate was 15% for the nine months ended September 30, 2014, compared to 61% for the nine months ended September 30, 2013. Factors that impacted the effective tax rate include the federal domestic production activities deduction, limitations on executive compensation, non-deductible stock-based compensation expense, and disqualifying dispositions of employee incentive stock options.
 
Nine Months Ended September 30,
 
2014
 
2013
 
$ Change
 
% Change
 
(in thousands)
Loss before income taxes
$
(126,036
)
 
$
(88,022
)
 
$
(38,014
)
 
43
%
Net loss
(107,510
)
 
(34,364
)
 
(73,146
)
 
213
%
Percentage of net revenues
(25
)%
 
(10
)%
 

 


During the nine months ended September 30, 2014, net loss was $107.5 million, an increase of $73.1 million as compared to a net loss of $34.4 million the same period in 2013. As a percentage of net revenues, net loss increased to 25% for the nine months ended September 30, 2014 from 10% for the nine months ended September 30, 2013.

Liquidity and Capital Resources

At September 30, 2014, we had $197.7 million of cash and cash equivalents and $102.6 million of investments, primarily agency securities and corporate bonds. To supplement our overall liquidity position, during the year ended December 31, 2013 we issued $300.0 million of 0.25% convertible senior notes due May 15, 2018. We also have access to a five-year senior secured syndicated credit facility to provide up to $200.0 million in additional capital resources. As of September 30, 2014, no amounts have been drawn against this facility.

Below is our cash flow activity for the nine months ended September 30, 2014 and 2013:
 
Nine Months Ended September 30,
 
2014
 
2013
 
(in thousands)
Consolidated Statements of Cash Flows Data:
 
 
 
Purchases of property and equipment
$
56,872

 
$
48,550

Capitalization of software and website development costs
15,539

 
12,057

Cash flows used in operating activities
(93,041
)
 
(71,272
)
Cash flows used in investing activities
(173,477
)
 
(101,554
)
Cash flows provided by / (used in) financing activities
(34,901
)
 
262,878


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

We anticipate that total 2014 capital expenditures will range from 9.5% to 10.5% of our expected net revenues in 2014, which includes additional investments related to our Shakopee, Minnesota production facility, which commenced operations in the second

27


quarter of 2014, our Tempe, Arizona production facility, which we expect will be operational in 2015, and the move and expansion of our co-location facility from California to Nevada.  These expenditures will be used to purchase technology and equipment to support the growth in our business, to increase our production capacity, and help enable us to respond more quickly and efficiently to customer demand. A smaller but significant 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. This range of capital expenditures is not outside the ordinary course of our business or materially different from how we have expanded our business in the past.

The following table shows total capital expenditures including amounts accrued but not yet paid by category for the nine months ended September 30, 2014 and 2013:
 
Nine Months Ended September 30,
 
2014
 
2013
 
(in thousands)
Technology equipment and software
$
31,070

 
$
24,002

Percentage of total capital expenditures
42
%
 
41
%
Manufacturing equipment and building improvements
23,445

 
23,042

Percentage of total capital expenditures
31
%
 
39
%
Capitalized technology and development costs
16,520

 
12,057

Percentage of total capital expenditures
22
%
 
20
%
Rental equipment
3,407

 

Percentage of total capital expenditures
5
%
 
%
Total capital expenditures
$
74,442

 
$
59,101

Total capital expenditures percentage of net revenues
17
%
 
16
%

Operating Activities. For the nine months ended September 30, 2014, net cash used in operating activities was $93.0 million, primarily due to our net loss of $107.5 million and the net change in operating assets and liabilities of $96.4 million. Net cash used in operating activities was adjusted for non-cash items including $44.5 million of stock-based compensation expense, $46.1 million of depreciation and amortization expense, $25.9 million of amortization of intangible assets and $14.9 million benefit from deferred income taxes.

For the nine months ended September 30, 2013, net cash used in operating activities was $71.3 million, primarily due to our net loss of $34.4 million and the net change in operating assets and liabilities of $123.9 million. Net cash used in operating activities was adjusted for non-cash items including $38.2 million of stock-based compensation, $30.7 million of depreciation and amortization expense, $22.2 million of amortization of intangible assets and $8.0 million benefit from deferred income taxes.

Investing Activities. For the nine months ended September 30, 2014, net cash used in investing activities was $173.5 million.  We used $117.3 million to purchase investments. We also used $56.9 million for capital expenditures for computer and network hardware to support our website infrastructure and information technology systems and for production equipment for our manufacturing and production operations and $15.5 million for capitalized software and website development. This was partially offset by proceeds from the sale of investments of $15.5 million.

For the nine months ended September 30, 2013, net cash used in investing activities was $101.6 million.  We used $41.1 million to acquire MyPublisher and R&R Images and to settle other acquisition related liabilities.  We also used $48.6 million for capital expenditures for computer and network hardware to support our website infrastructure and information technology systems and for production equipment for our manufacturing and production operations and $12.1 million for capitalized software and website development.

Financing Activities. For the nine months ended September 30, 2014, net cash used in financing activities was $34.9 million. We used $50.5 million to repurchase shares of our common stock. We also recorded $14.1 million in excess tax benefit from stock-based compensation expense and $3.1 million of proceeds from the issuance of common stock from the exercise of stock options.

For the nine months ended September 30, 2013, net cash provided by financing activities was $262.9 million, primarily from the $291.9 million in proceeds from the issuance of our 0.25% convertible senior notes in May 2013, $43.6 million in proceeds from the issuance of warrants, offset by $63.5 million from the purchase of a convertible note hedge and repurchases of common

28


stock of $32.2 million. We also received $18.3 million of proceeds from issuance of common stock from the exercise of options and recorded $5.4 million from excess tax benefit 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 three financial measures, adjusted EBITDA, free cash flow, and Non-GAAP earnings per share 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. Free cash flow has limitations due to the fact that it does not represent the residual cash flow for discretionary expenditures. For example, free cash flow does not incorporate payments made on capital lease obligations or cash requirements to comply with debt covenants. Non-GAAP earnings per share is defined as Non-GAAP net income (loss), which excludes interest expense related to the issuance of our 0.25% convertible senior notes in May 2013, divided by diluted non-GAAP shares outstanding, which is GAAP weighted average shares outstanding less any shares issuable under our convertible senior notes. 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 adjusted EBITDA, free cash flow, and Non-GAAP earnings per share to the most comparable GAAP measure.

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

The table below shows the trend of adjusted EBITDA and free cash flow as a percentage of net revenues and Non-GAAP net loss per share for the three and nine months ended September 30, 2014 and 2013 (in thousands, except per share amounts):
 
Three Months Ended
September 30,
 
Nine Months Ended
September 30,
 
2014
 
2013
 
2014
 
2013
Net revenues
$
142,008

 
$
122,685

 
$
438,255

 
$
372,854

 
 
 
 
 
 
 
 
Non-GAAP adjusted EBITDA
$
(9,724
)
 
$
(1,067
)
 
$
2,191

 
$
8,541

EBITDA % of net revenues
(7
)%
 
(1
)%
 
 %
 
2
 %
 
 
 
 
 
 
 
 
Free cash flow
$
(34,577
)
 
$
(25,717
)
 
$
(72,251
)
 
$
(50,560
)
Free cash flow % of net revenues
(24
)%
 
(21
)%
 
(16
)%
 
(14
)%
 
 
 
 
 
 
 
 
Non-GAAP net loss per share
$
(1.12
)
 
$
(0.24
)
 
$
(2.57
)
 
$
(0.86
)

For the three months ended September 30, 2014 and 2013, our adjusted EBITDA was $(9.7) million and $(1.1) million, respectively. For the nine months ended September 30, 2014 and 2013, our adjusted EBITDA was $2.2 million and $8.5 million, respectively. In addition, during the three months ended September 30, 2014 and 2013, we experienced negative free cash flows of $34.6 million and $25.7 million, respectively. In addition, during the nine months ended September 30, 2014 and 2013, we experienced negative free cash flows of $72.3 million and $50.6 million, respectively. Our Non-GAAP net loss per share was $1.12 and $0.24 for the three months ended September 30, 2014 and 2013, respectively. Our Non-GAAP net loss per share was $2.57 and $0.86 for the nine months ended September 30, 2014 and 2013, respectively. By carefully managing our operating costs and capital expenditures, we are able to make the strategic investments we believe are necessary to grow and strengthen our business while maintaining the opportunity for full year adjusted EBITDA profitability and positive free cash flows.


29


The following is a reconciliation of adjusted EBITDA, free cash flow, and Non-GAAP earnings/(loss) per share to the most comparable GAAP measure, for the three and nine months ended September 30, 2014 and 2013 (in thousands):
Reconciliation of Net Loss to Non-GAAP Adjusted EBITDA
Three Months Ended
 
Nine Months Ended
 
September 30,
 
September 30,
 
2014
 
2013
 
2014
 
2013
Net loss
$
(46,244
)
 
$
(10,148
)
 
$
(107,510
)
 
$
(34,364
)
Add back:
 

 
 

 
 

 
 

Interest expense
4,381

 
3,609

 
12,184

 
5,684

Interest and other income, net
(102
)
 
(139
)
 
(383
)
 
(181
)
Benefit from income taxes
(6,962
)
 
(27,944
)
 
(18,526
)
 
(53,658
)
Depreciation and amortization
25,415

 
19,573

 
71,932

 
52,891

Stock-based compensation expense
13,788

 
13,982

 
44,494

 
38,169

Non-GAAP Adjusted EBITDA
$
(9,724
)
 
$
(1,067
)
 
$
2,191

 
$
8,541

 
Reconciliation of Cash Flow from Operating Activities to Non-GAAP Adjusted EBITDA and Free Cash Flow
Three Months Ended
 
Nine Months Ended
 
September 30,
 
September 30,
 
2014
 
2013
 
2014
 
2013
Net cash used in operating activities
$
(7,850
)
 
$
309

 
$
(93,041
)
 
$
(71,272
)
Add back:
 

 
 

 
 

 
 

Interest expense
4,381

 
3,609

 
12,184

 
5,684

Interest and other income, net
(102
)
 
(139
)
 
(383
)
 
(181
)
Benefit from income taxes
(6,962
)
 
(27,944
)
 
(18,526
)
 
(53,658
)
Changes in operating assets and liabilities
(2,521
)
 
19,961

 
96,377

 
123,942

Other adjustments
3,330

 
3,137

 
5,580

 
4,026

Non-GAAP Adjusted EBITDA
(9,724
)
 
(1,067
)
 
2,191

 
8,541

Less:
 

 
 

 
 

 
 

Purchases of property and equipment, including accrued amounts
(18,769
)
 
(20,343
)
 
(57,922
)
 
(47,044
)
Capitalized software and website development costs, including accrued amounts
(6,084
)
 
(4,307
)
 
(16,520
)
 
(12,057
)
Free cash flow
$
(34,577
)
 
$
(25,717
)
 
$
(72,251
)
 
$
(50,560
)


30


Reconciliation of Net Loss per Share to Non-GAAP Net Loss per Share
Three Months Ended
 
Nine Months Ended
 
September 30,
 
September 30,
 
2014
 
2013
 
2014
 
2013
GAAP net loss
$
(46,244
)
 
$
(10,148
)
 
$
(107,510
)
 
$
(34,364
)
Add back interest expense related to:
 

 
 

 
 

 
 

Amortization of debt discount
2,951

 
2,771

 
8,732

 
4,172

Amortization of debt issuance costs
297

 
260

 
878

 
420

0.25% coupon
187

 
188

 
562

 
281

Tax effect
(395
)
 
(2,046
)
 
(1,470
)