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EX-31.01 - EXHIBIT 31.01 - SHUTTERFLY INCex31_01q3-15.htm
EX-32.01 - EXHIBIT 32.01 - SHUTTERFLY INCex32_01q3-15.htm
EX-31.02 - EXHIBIT 31.02 - SHUTTERFLY INCex31_02q3-15.htm
EX-32.02 - EXHIBIT 32.02 - SHUTTERFLY INCex32_02q3-15.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, 2015
 
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 November 3, 2015
Common stock, $0.0001 par value per share
 
35,136,469
 

1


TABLE OF CONTENTS

 
Page
Number
Part I - Financial Information
 
Item 1. Financial Statements
 
Part II - Other Information
 







2


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, 2015
 
December 31, 2014
ASSETS
 
 
 
Current assets:
 
 
 
Cash and cash equivalents
$
96,451

 
$
380,543

Short-term investments
37,616

 
64,866

Accounts receivable, net
48,902

 
31,105

Inventories
11,610

 
13,016

Deferred tax asset, current portion
36,652

 
34,645

Prepaid expenses and other current assets
37,751

 
24,983

Total current assets
268,982

 
549,158

Long-term investments
8,718

 
29,928

Property and equipment, net
285,566

 
241,742

Intangible assets, net
68,187

 
87,950

Goodwill
408,975

 
408,975

Deferred tax asset, net of current portion
549

 
549

Other assets
11,992

 
13,976

Total assets
$
1,052,969

 
$
1,332,278

LIABILITIES AND STOCKHOLDERS’ EQUITY
 
 
 
Current liabilities:
 
 
 
Accounts payable
$
14,904

 
$
30,086

Accrued liabilities
76,047

 
135,485

Deferred revenue
25,590

 
31,415

Total current liabilities
116,541

 
196,986

Convertible senior notes, net
264,452

 
255,218

Deferred tax liability
35,734

 
48,090

Other liabilities
114,672

 
74,178

Total liabilities
531,399

 
574,472

Commitments and contingencies (Note 11)

 

Stockholders’ equity:
 
 
 
Common stock, $0.0001 par value; 100,000 shares authorized; 35,446 and 37,906 shares issued and outstanding on September 30, 2015 and December 31, 2014, respectively
4

 
4

Additional paid-in capital
901,737

 
838,313

Accumulated other comprehensive income/(loss)
30

 
(53
)
Accumulated deficit
(380,201
)
 
(80,458
)
Total stockholders' equity
521,570

 
757,806

Total liabilities and stockholders' equity
$
1,052,969

 
$
1,332,278

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

3


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

 
Three Months Ended
 
Nine Months Ended
 
September 30,
 
September 30,
 
2015
 
2014
 
2015
 
2014
Net revenues
$
167,492

 
$
142,008

 
$
511,349

 
$
438,255

Cost of net revenues
107,991

 
89,726

 
299,345

 
249,404

Gross profit
59,501

 
52,282

 
212,004

 
188,851

Operating expenses:
 

 
 

 
 

 
 

Technology and development
38,066

 
33,488

 
111,928

 
97,102

Sales and marketing
43,052

 
42,082

 
138,028

 
128,695

General and administrative
27,449

 
25,639

 
85,730

 
77,289

Total operating expenses
108,567

 
101,209

 
335,686

 
303,086

Loss from operations
(49,066
)
 
(48,927
)
 
(123,682
)
 
(114,235
)
Interest expense
(5,613
)
 
(4,381
)
 
(15,334
)
 
(12,184
)
Interest and other income, net
433

 
102

 
655

 
383

Loss before income taxes
(54,246
)
 
(53,206
)
 
(138,361
)
 
(126,036
)
Benefit from/(provision for) income taxes
(8,831
)
 
6,962

 
6,404

 
18,526

Net loss
$
(63,077
)
 
$
(46,244
)
 
$
(131,957
)
 
$
(107,510
)
 
 
 
 
 
 
 
 
Net loss per share - basic and diluted
$
(1.73
)
 
$
(1.20
)
 
$
(3.54
)
 
$
(2.79
)
 
 
 
 
 
 
 
 
Weighted-average shares outstanding - basic and diluted
36,369

 
38,453

 
37,291

 
38,470

 
 
 
 
 
 
 
 
Stock-based compensation is allocated as follows:
 
 
 

 
 
 
 
Cost of net revenues
$
952

 
$
886

 
$
3,145

 
$
2,782

Technology and development
2,443

 
1,320

 
7,744

 
6,196

Sales and marketing
5,329

 
5,591

 
17,202

 
16,837

General and administrative
7,032

 
5,991

 
21,740

 
18,679


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

4


SHUTTERFLY, INC.
CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME/(LOSS)
(In thousands)
(Unaudited)
 
Three Months Ended
 
Nine Months Ended
 
September 30,
 
September 30,
 
2015
 
2014
 
2015
 
2014
Net loss
$
(63,077
)
 
$
(46,244
)
 
$
(131,957
)
 
$
(107,510
)
Other comprehensive income/(loss), net of reclassification adjustments:
 
 
 
 
 
 
 
Unrealized gains/(losses) on investments, net
31

 
(35
)
 
134

 
(53
)
Tax benefit/(expense) on unrealized gains/losses on investments, net
(12
)
 
14

 
(51
)
 
21

Other comprehensive income/(loss), net of tax
19

 
(21
)
 
83

 
(32
)
Comprehensive loss
$
(63,058
)
 
$
(46,265
)
 
$
(131,874
)
 
$
(107,542
)

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,
 
2015
 
2014
Cash flows from operating activities:
 
 
 
Net loss
$
(131,957
)
 
$
(107,510
)
Adjustments to reconcile net loss to net cash used in operating activities:
 

 
 

Depreciation and amortization
63,435

 
46,079

Amortization of intangible assets
20,798

 
25,853

Amortization of debt discount and debt issuance costs
10,163

 
9,610

Stock-based compensation, net of forfeitures
49,831

 
44,494

Loss on disposal of property and equipment and rental assets
1,475

 
51

Deferred income taxes
(14,414
)
 
(14,852
)
Tax benefit from stock-based compensation
13,041

 
13,713

Excess tax benefits from stock-based compensation
(13,666
)
 
(14,102
)
Changes in operating assets and liabilities:
 

 
 

Accounts receivable, net
(17,797
)
 
(4,338
)
Inventories
1,406

 
(6,650
)
Prepaid expenses and other current assets
(12,767
)
 
(22,064
)
Other assets
621

 
(2,391
)
Accounts payable
(14,157
)
 
(5,710
)
Accrued and other liabilities
(66,401
)
 
(62,447
)
Deferred revenue
(5,825
)
 
7,719

Other non-current liabilities
8,514

 
(496
)
Net cash used in operating activities
(107,700
)
 
(93,041
)
Cash flows from investing activities:
 

 
 

Purchases of property and equipment
(46,448
)
 
(56,872
)
Capitalization of software and website development costs
(15,448
)
 
(15,539
)
Purchases of investments
(4,400
)
 
(117,329
)
Maturities and sales of investments
52,460

 
15,520

Proceeds from sale of property and equipment and rental assets
1,128

 
743

Acquisition of business and intangible assets, net of cash acquired
(127
)
 

Net cash used in investing activities
(12,835
)
 
(173,477
)
Cash flows from financing activities:
 

 
 

Proceeds from issuance of common stock upon exercise of stock options
2,670

 
3,058

Repurchases of common stock
(134,084
)
 
(50,520
)
Prepayment of accelerated share repurchase
(75,000
)
 

Refund of accelerated share repurchase
38,179

 

Excess tax benefits from stock-based compensation
13,666

 
14,102

Principal payments of capital lease and financing obligations
(8,988
)
 
(1,541
)
Net cash used in financing activities
(163,557
)
 
(34,901
)
Net decrease in cash and cash equivalents
(284,092
)
 
(301,419
)
Cash and cash equivalents, beginning of period
380,543

 
499,084

Cash and cash equivalents, end of period
$
96,451

 
$
197,665



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

6



 
Nine Months Ended
 
September 30,
 
2015
 
2014
Supplemental schedule of non-cash activities:
 

 
 

Net increase/(decrease) in accrued purchases of property and equipment
$
(154
)
 
$
1,050

Net increase in accrued capitalized software and website development costs
363

 
981

Increase in estimated fair market value of buildings under build-to-suit leases
17,161

 
17,575

Property and equipment acquired under capital leases
29,097

 
6,831

Amount due from adjustment of net working capital from acquired business

 
253


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 ("U.S. GAAP") 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, 2015 are not necessarily indicative of the results that may be expected for the year ending December 31, 2015, or for any other period.

The December 31, 2014 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, 2014 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, 2015.

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.

The Company assesses its ability to recover its deferred tax assets on an ongoing basis. Significant management judgment is required in determining any valuation allowance recorded against deferred tax assets. In evaluating the ability to recover deferred tax assets, the Company considers available positive and negative evidence including its recent cumulative losses, its ability to carry-back losses against prior taxable income and its projected financial results. The Company also considers, commensurate with its objective verifiability, the forecast of future taxable income including the reversal of temporary differences and the implementation of feasible and prudent tax planning strategies. A valuation allowance may be recorded in the event it is deemed to be more-likely-than-not that the deferred tax asset cannot be realized. If recorded, it would have an adverse impact on the Company’s operating results.

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

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, 2015 and December 31, 2014.

The Company’s analysis of the need for a valuation allowance considered that the Company has incurred a cumulative loss in the U.S. over the three year period ending September 30, 2015. A majority of the cumulative loss has been caused by non-recurring cost related to the Company’s expansions in manufacturing capacity, restructuring and integration activities in the past few years to prepare for future growth. The Company anticipates a return to full year profitability in fiscal 2016. Consideration has also been given to the Company’s history of utilizing Federal tax loss carryforwards prior to expiration, the expected reversal dates of the significant deferred tax liabilities, i.e., within the federal NOL and R&D credit carryforward periods, inclusive of any IRC Section 382 limitations.

Based on the Company’s assessment, excluding the valuation allowance recorded prior to September 30, 2015 related to certain California and South Carolina deferred tax assets that are not likely to be realized, it is more likely than not that the Company’s other U.S. net deferred tax asset will be realized through future taxable earnings, and/or the reversal of existing taxable temporary differences. If necessary, the Company would pursue any possible tax planning strategies to avoid the valuation allowance. Accordingly, no additional valuation allowance has been recorded on this net asset as of September 30, 2015. The Company will continue to assess the need for a valuation allowance in the future.
If future results are less than projected in the U.S. and if tax planning alternatives do not offset those effects, a valuation allowance may be required to reduce the deferred tax asset, which would impact the Company’s results of operations in the period in which it is recorded.
The Company is subject to taxation in jurisdictions within the United States and Israel.

Segment Reporting

The Company reports as two operating segments with the Chief Executive Officer (“CEO”) acting as the Company’s chief operating decision maker. The Company defined two reportable segments based on factors such as how management manages the operations and how its chief operating decision maker views results. The Company has the following reportable segments:

9

SHUTTERFLY, INC.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

Consumer - Includes sales from the Company's 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 its BorrowLenses brand.
Enterprise - Includes revenues primarily from variable, four-color direct marketing collateral manufactured and fulfilled for business customers.

In addition to the above reportable segments, the Company has a corporate category that includes activities that are not directly attributable or allocable to a specific segment. This category consists of stock-based compensation and amortization of intangible assets.

Revenue Recognition

The Company recognizes revenue from Consumer and Enterprise product sales, net of applicable sales tax, upon shipment of fulfilled orders, when persuasive evidence of an arrangement exists, the selling price is fixed or determinable and collection of resulting receivables is reasonably assured. Customers place Consumer product orders through the Company's websites and pay primarily using credit cards. Enterprise customers are invoiced upon fulfillment. Shipping charged to customers is recognized as revenue at the time of shipment.

For camera, lenses, and video equipment rentals from its BorrowLenses brand, the Company recognizes rental revenue and the related shipping and insurance revenue, ratably over the rental period. Revenue from the sale of rental equipment is recognized upon shipment of the equipment.

For gift card sales and flash deal promotions through group buying websites, the Company recognizes revenue on a gross basis, as it is the primary obligor, when redeemed items are shipped. Revenues from sales of prepaid orders on its websites are deferred until shipment of fulfilled orders or until the prepaid period expires. The Company’s share of revenue generated from its print to retail relationships, is recognized when orders are picked up by its customers at the respective retailer.

In the second quarter of 2015, the Company changed its accounting estimate related to flash deal deferred revenue. Beginning in 2010, the Company began to market product offers on flash deal websites such as Groupon and LivingSocial. With limited history as to customer redemption patterns, the Company had been deferring all amounts to a flash deal deferred revenue liability until customer redemption. The Company now has sufficient relevant historical flash deal redemption data to support a change in estimate of the flash deal deferred revenue based on historical customer redemption patterns. The historical data supports the probability of redemption after two years from the issuance of a flash deal offer as remote. In addition, the Company's attempts to re-market the unredeemed flash deals over the last six months resulted in no meaningful change in customer behavior. Accordingly, flash deal breakage revenue is now recognized based upon its historical redemption patterns and represents the unredeemed flash deal offers for which the Company believes customer redemption is remote and it is not probable that the Company has an obligation to escheat the value of the flash deal revenue under unclaimed property laws. In the second quarter of 2015, the Company recognized a revenue catch-up of $7.5 million associated with this change.

The Company provides its customers with a 100% satisfaction guarantee whereby products can be returned within a 30-day period for a reprint or refund. The Company maintains an allowance for estimated future returns based on historical data. The provision for estimated returns is included in accrued expenses.

The Company periodically provides incentive offers to its customers in exchange for setting up an account and to encourage purchases. Such offers include free products and percentage discounts on current purchases. Discounts, when accepted by customers, are treated as a reduction to the purchase price of the related transaction and are presented in net revenues. Production costs related to free products are included in cost of revenues upon redemption.

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, 2014.

In May 2014, the Financial Accountings Standards Board ("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

10

SHUTTERFLY, INC.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

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 January 1, 2018 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, if any, of adopting this new accounting guidance 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.

In April 2015, the FASB issued new guidance related to presentation of debt issue costs. The new standard requires that debt issuance costs related to a recognized debt liability be presented in the balance sheet as a direct deduction from the carrying amount of that debt liability. The adoption of this guidance will be effective for the Company beginning January 1, 2016, and is not expected to have a material impact on the Company's financial statements.

In April 2015, the FASB issued new guidance related to accounting for fees paid in a cloud computing arrangement. The new standard provides guidance to customers about whether a cloud computing arrangement includes a software license. If a cloud computing arrangement includes a software license, then the customer should account for the software license element of the arrangement consistent with the acquisition of other software licenses. If a cloud computing arrangement does not include a software license, the customer should account for the arrangement as a service contract. The adoption of this guidance will be effective for the Company beginning January 1, 2016, and is not expected to have a material impact on the Company's financial statements.

In July 2015, the FASB issued ASU 2015-11, Inventory - Simplifying the Measurement of Inventory (Topic 330). ASU 2015-11 requires inventory to be subsequently measured using the lower of cost and net realizable value, thereby eliminating the market value approach. Net realizable value is defined as the “estimated selling prices in the ordinary course of business, less reasonably predictable costs of completion, disposal and transportation.” ASU 2015-11 is effective for reporting periods beginning after December 15, 2016 and is applied prospectively. Early adoption is permitted. The Company is evaluating the impact, if any, of adopting this new accounting guidance on its financial statements.

In September 2015, the FASB issued new guidance related to business combinations. The new guidance requires that adjustments made to provisional amounts recognized in a business combination be recorded in the period such adjustments are determined, rather than retrospectively adjusting previously reported amounts. The new standard is effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2015. Early adoption is permitted. We are evaluating the impact, if any, of adopting this new accounting guidance on our consolidated financial statements.


11

SHUTTERFLY, INC.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

Note 2 — Stock-Based Compensation

Stock Option Activity

A summary of the Company’s stock option activity for the three and nine months ended September 30, 2015 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, 2014
402

 
$
25.42

 
 
 
 
Granted

 

 
 
 
 
Exercised
(60
)
 
19.56

 
 
 
 
Forfeited, cancelled or expired
(5
)
 
46.45

 
 
 
 
Balances, March 31, 2015
337

 
$
26.15

 
4.4
 
$
6,771

Granted

 

 
 
 
 
Exercised
(54
)
 
21.31

 
 
 
 
Forfeited, cancelled or expired
(8
)
 
39.87

 
 
 
 
Balances, June 30, 2015
275

 
$
26.67

 
4.1
 
$
5,992

Granted

 

 
 
 
 
Exercised
(24
)
 
14.72

 
 
 
 
Forfeited, cancelled or expired
(7
)
 
39.64

 
 
 
 
Balances, September 30, 2015
244

 
$
27.48

 
3.7
 
$
2,889

Options vested and expected to vest at September 30, 2015
243

 
$
27.48

 
3.7
 
$
2,886

Options vested at September 30, 2015
230

 
$
27.40

 
3.5
 
$
2,794

 
During the three and nine months ended September 30, 2015, the Company did not grant any options. The total intrinsic value of options exercised during the three and nine months ended September 30, 2015 was $0.7 million and $3.6 million, respectively.  Net cash proceeds from the exercise of stock options were $0.4 million and $2.7 million for the three and nine months ended September 30, 2015, respectively.

Restricted Stock Unit Activity

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.


12

SHUTTERFLY, INC.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

A summary of the Company’s RSU activity for the three and nine months ended September 30, 2015, is as follows (share numbers in thousands):
 
Number of
Units
Outstanding
 
Weighted
Average
Grant Date
Fair Value
Awarded and unvested, December 31, 2014
3,704

 
$
42.17

Granted
1,459

 
45.03

Vested
(926
)
 
38.18

Forfeited
(206
)
 
45.22

Awarded and unvested, March 31, 2015
4,031

 
$
43.96

Granted
275

 
46.74

Vested
(195
)
 
34.96

Forfeited
(137
)
 
43.97

Awarded and unvested, June 30, 2015
3,974

 
$
44.60

Granted
206

 
42.40

Vested
(122
)
 
40.85

Forfeited
(112
)
 
45.06

Awarded and unvested, September 30, 2015
3,946

 
$
44.58

RSUs expected to vest, September 30, 2015
3,450

 
 

 
Included in the RSU grants for the nine months ended September 30, 2015, are 681,000 RSUs that have both performance criteria tied to the Company’s 2015 financial performance and four year service criteria, as well as grants made to the CEO that vest upon the achievement of 2015 financial performance and two-year 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, 2015 and 2014, 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, 2015, the Company had $103.4 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 senior notes.


13

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, 2015 and 2014 is as follows (in thousands, except per share amounts):
 
Three Months Ended
 
Nine Months Ended
 
September 30,
 
September 30,
 
2015
 
2014
 
2015
 
2014
Net loss per share:
 
 
 
 
 
 
 
Numerator
 
 
 
 
 
 
 
Net loss
$
(63,077
)
 
$
(46,244
)
 
$
(131,957
)
 
$
(107,510
)
Denominator for basic and diluted net loss per share
 

 
 

 
 
 
 
Weighted-average common shares outstanding
36,369

 
38,453

 
37,291

 
38,470

Net loss per share — basic and diluted
$
(1.73
)
 
$
(1.20
)
 
$
(3.54
)
 
$
(2.79
)

Note 4 — Investments

At September 30, 2015 and December 31, 2014, the estimated fair value of short-term and long-term investments classified as available for sale are as follows (in thousands):
 
 
September 30, 2015
 
 
Amortized Cost
 
Gross Unrealized Gains
 
Gross Unrealized Losses
 
Estimated Fair Value
Short-term investments
 
 
 
 
 
 
 
 
Corporate debt securities
 
$
31,335

 
$
5

 
$
(4
)
 
$
31,336

Agency securities
 
6,275

 
5

 

 
6,280

Total short-term investments
 
$
37,610

 
$
10

 
$
(4
)
 
$
37,616

Long-term investments
 
 
 
 
 
 
 
 
Corporate debt securities
 
$

 
$

 
$

 
$

Agency securities
 
6,878

 
31

 

 
6,909

US Government securities
 
1,799

 
10

 

 
1,809

Total long-term investments
 
$
8,677

 
$
41

 
$

 
$
8,718


 
 
December 31, 2014
 
 
Amortized Cost
 
Gross Unrealized Gains
 
Gross Unrealized Losses
 
Estimated Fair Value
Short-term investments
 
 
 
 
 
 
 
 
Corporate debt securities
 
$
64,922

 
$
3

 
$
(59
)
 
$
64,866

Agency securities
 

 

 

 

Total short-term investments
 
$
64,922

 
$
3

 
$
(59
)
 
$
64,866

Long-term investments
 
 
 
 
 
 
 
 
Corporate debt securities
 
$
14,511

 
$
1

 
$
(30
)
 
$
14,482

Agency securities
 
13,649

 
3

 
(7
)
 
13,645

US Government securities
 
1,799

 
2

 

 
1,801

Total long-term investments
 
$
29,959

 
$
6

 
$
(37
)
 
$
29,928


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, 2015 and no impairments were recorded in the period. The Company had no material realized gains or losses during the nine months ended September 30, 2015.


14

SHUTTERFLY, INC.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

The following table summarizes the contractual maturities of the Company's investments as of September 30, 2015 (in thousands):
 
September 30, 2015
One year or less
$
37,616

One year through three years
8,718

 
$
46,334


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

Note 5 — Fair Value Measurement

Cash Equivalents and Investments

The Company measures the fair value of money market funds and investments based on quoted prices in active markets for identical assets or liabilities. All other financial instruments were valued either based on recent trades of securities in inactive markets or based on quoted market prices of similar instruments and other significant inputs derived from or corroborated by observable market data. The Company did not hold any cash equivalents or investments categorized as Level 3 as of September 30, 2015.

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, 2015
 
December 31, 2014
Level 1 Securities:
 
 
 
Money market funds
$
31,175

 
$
34,480

Level 2 Securities:
 
 
 
Agency securities
13,189

 
13,645

Corporate debt securities
31,336

 
79,348

US Government securities
1,809

 
1,801

Total cash equivalents and investments
$
77,509

 
$
129,274


Convertible Senior Notes

As of September 30, 2015, 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, 2015
 
December 31, 2014
Convertible senior notes
$
266,706

 
$
251,973



15

SHUTTERFLY, INC.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

Note 6 — Balance Sheet Components

Prepaid Expenses and Other Current Assets
 
September 30,
2015
 
December 31,
2014
 
(in thousands)
Prepaid marketing
$
9,320

 
$
446

Prepaid service contracts – current portion
7,748

 
6,754

Intra-period deferred tax asset
5,023

 

Deferred costs
3,824

 
6,911

Other prepaid expenses and current assets
11,836

 
10,872

 
$
37,751

 
$
24,983


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.

Other Assets
 
September 30,
2015
 
December 31,
2014
 
(in thousands)
Other assets
$
11,992

 
$
13,976


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 Senior Notes, the long-term portion of prepaid service contracts, and deposits on long-term leases and other contracts.

Property and Equipment, Net
 
September 30,
2015
 
December 31,
2014
 
(in thousands)
Computer equipment and software
$
169,219

 
$
159,370

Manufacturing equipment
147,336

 
119,495

Capitalized software and website development costs
103,819

 
89,311

Buildings under build-to-suit leases
56,468

 
39,307

Leasehold improvements
21,307

 
20,876

Rental equipment
17,013

 
14,591

Furniture and fixtures
11,795

 
10,683

 
526,957

 
453,633

Less: Accumulated depreciation and amortization
(241,391
)
 
(211,891
)
Net property and equipment
$
285,566

 
$
241,742

 
Building value of $56.5 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 11 - Commitments and Contingencies for further discussion of the Company's build-to-suit leases.

Included within Manufacturing equipment is approximately $73.0 million of capital lease obligations. Accumulated depreciation of assets under capital lease totaled $10.8 million at September 30, 2015.

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


16

SHUTTERFLY, INC.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

Depreciation and amortization expense totaled $22.6 million and $16.9 million for the three months ended September 30, 2015 and 2014, respectively. Depreciation and amortization expense totaled $63.4 million and $46.1 million for the nine months ended September 30, 2015 and 2014, respectively.

Accrued Liabilities
 
September 30,
2015
 
December 31,
2014
 
(in thousands)
Accrued production costs
$
17,860

 
$
32,814

Capital lease obligations
14,042

 
8,905

Accrued compensation
12,882

 
16,337

Accrued marketing expenses
8,806

 
30,835

Accrued purchases
5,753

 
11,809

Accrued consulting
4,292

 
6,418

Accrued income, sales, and property taxes
3,909

 
18,149

Accrued other
8,503

 
10,218

 
$
76,047

 
$
135,485

 
Other Liabilities
 
September 30,
2015
 
December 31,
2014
 
(in thousands)
Financing obligations
$
57,092

 
$
38,529

Capital lease obligations
47,945

 
32,297

Deferred revenue
5,730

 

Other liabilities
3,905

 
3,352

 
$
114,672

 
$
74,178


Financing obligations relate to the Company's build-to-suit leases as further discussed in Note 11 - Commitments and Contingencies.

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:

17

SHUTTERFLY, INC.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS


during any calendar quarter commencing after the calendar quarter ending on September 30, 2013 (and only during such calendar quarter), if the last reported sale price of the Company's common stock for at least 20 trading days (whether or not consecutive) during a period of 30 consecutive trading days ending on the last trading day of the immediately preceding calendar quarter is greater than or equal to 130% of the conversion price on each applicable trading day;
during the five business day period after any ten consecutive trading day period (the “Notes Measurement Period”) in which the "trading price" (as the term is defined in the Indenture) per $1,000 principal amount of notes for each trading day of such Notes Measurement Period was less than 98% of the product of the last reported sale price of the Company's common stock on such trading day and the conversion rate on each such trading day;
upon the occurrence of specified corporate events; or
at any time on or after December 15, 2017 until the close of business on the second scheduled trading immediately preceding the maturity date.
As of September 30, 2015, 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, 2015
 
December 31, 2014
Liability component:
 
 
 
 
Principal
 
$
300,000

 
$
300,000

Less: debt discount, net of amortization
 
(35,548
)
 
(44,782
)
Net carrying amount
 
$
264,452

 
$
255,218

 
 
 
 
 
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
 
Nine Months Ended
 
 
September 30,
 
September 30,
 
 
2015
 
2014
 
2015
 
2014
0.25% coupon
 
$
188

 
$
187

 
$
563

 
$
562

Amortization of debt issuance costs
 
314

 
297

 
929

 
878

Amortization of debt discount
 
3,120

 
2,951

 
9,233

 
8,732

 
 
$
3,622

 
$
3,435

 
$
10,725

 
$
10,172

 


18

SHUTTERFLY, INC.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

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

Note 8 — Share Repurchase Program

On October 24, 2012, the Company's Board of Directors conditionally authorized and the Audit Committee subsequently approved a share repurchase program for up to $60.0 million of the Company's common stock. 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. On February 9, 2015, the Company's Board of Director's approved an increase to the program, authorizing the Company to repurchase up to $300.0 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 the Company to repurchase any dollar amount or number of shares; and may be suspended or discontinued at any time. The share repurchase authorization, which was effective immediately, permits the Company to effect repurchases for cash from time to time through open market, privately negotiated or other transactions, including pursuant to trading plans established in accordance with Rules 10b5-1 and 10b-18 of the Securities Exchange Act of 1934, as amended, or by a combination of such methods.
In May 2015, the Company entered into an accelerated share repurchase agreement (“ASR”) with a financial institution to repurchase shares of its common stock. Under the ASR, the Company prepaid $75.0 million in the second quarter of 2015. The Company accounted for the ASR as a forward contract indexed to the Company’s own common stock. The Company has determined that the forward contract, indexed to its common stock, met all of the applicable criteria for equity classification.
The final settlement occurred on August 3, 2015 and approximately 0.8 million shares were delivered to the company. The Company received a return of cash for the remaining amount not settled in shares of $38.2 million.. In total, approximately 0.8 million shares of common stock were repurchased under the ASR for $36.8 million, resulting in an average price paid per share of $46.49 under the ASR. The ASR was entered into pursuant to the Company’s existing share repurchase program.
In total during the first nine months of 2015, the Company repurchased 3.8 million shares of its outstanding common stock at an average price of $44.51 per share pursuant to the share repurchase program and including the shares repurchased under the ASR settled in the third quarter of 2015.
In 2014, the Company repurchased 2.0 million shares of its outstanding common stock at an average price of $45.29 per share pursuant to the share repurchase program. All repurchased shares of common stock have been retired.
In 2013, the Company repurchased 0.1 million shares of its outstanding common stock at an average price of $31.87 per share pursuant to the share repurchase program. All repurchased shares of common stock have been retired.


19

SHUTTERFLY, INC.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

Note 9 — Restructuring

During the first quarter of 2015, the Company decided to discontinue the Treat brand as well as close the manufacturing operations in Elmsford, New York as part of the Company's strategic initiatives. The assets related to the Treat brand were written off in the first quarter of 2015 upon discontinuation of the Treat brand. In the third quarter of 2015, the Company stopped production at the Elmsford, New York manufacturing facility and ceased-use of the manufacturing space. As a result of exiting the facility prior to the lease termination date, the Company recorded a liability of $2.1 million for the net present value of future rent payments, adjusted for potential sublease income. The Company will continue to incur employee severance and benefit expenses due to a reduction to headcount as a result of the restructuring activities. These restructuring costs will impact cost of net revenues and operating expenses through the first quarter of 2016.

The following table summarizes the restructuring costs recognized during the three and nine months ended September 30, 2015:
 
Three Months Ended September 30, 2015
 
Nine Months Ended September 30, 2015
 
(in thousands)
Employee severance and benefits
$
151

 
$
927

Other associated costs
2,059

 
2,494

Total
$
2,210

 
$
3,421


The following table summarizes the restructuring activity during the three and nine months ended September 30, 2015:
 
Employee Severance and Benefits
 
Other Associated Costs
 
Total
Accrued liability as of January 1, 2015
$

 
$

 
$

Charges
467

 
435

 
902

Payments

 

 

Other adjustments

 
(435
)
 
(435
)
Accrued liability as of March 31, 2015
$
467

 
$

 
$
467

Charges
309

 

 
309

Payments
(284
)
 

 
(284
)
Other Adjustments

 

 

Accrued liability as of June 30, 2015
$
492

 
$

 
$
492

Charges
151

 
2,059

 
2,210

Payment
(270
)
 

 
(270
)
Other Adjustments

 

 

Accrued liability as of September 30, 2015
$
373

 
$
2,059

 
$
2,432


Note 10 — Segment Reporting

The Company reports segment information based on the "management" approach. The management approach designates the internal reporting used by management for making decisions and assessing performance as the source of its reportable segments.
    
The Company's Chief Operating Decision Maker ("CODM") function is comprised of its chief executive officer. Effective in the fourth quarter of 2014, the Company defined two reportable segments based on factors such as how management manages the operations and how the chief operating decision maker views results. Prior to the fourth quarter of 2014, the Company reported as a single operating and reportable segment. Accordingly, the Company has recasted its financial information and disclosures for prior periods to reflect the segment disclosures as if the current operating structure had been in effect throughout all periods presented.

The CODM function uses gross profit to evaluate the performance of the segments and allocate resources. Management considers gross margin to be the appropriate metric to evaluate and compare the ongoing performance of each reportable segment as it is the level which direct costs associated with the performance of the segment are monitored. Cost of revenue for the Consumer

20

SHUTTERFLY, INC.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

segment consists of costs directly attributable to the production of personalized products for all of the Company's brands, including direct materials, shipping charges, and payroll and related expenses for direct labor; rent for production facilities, and depreciation of production equipment and facilities where the Company is the deemed owner. Cost of net revenues for the Enterprise segment consists of costs which are direct and incremental to the Enterprise business. These include production costs of Enterprise products, such as materials, labor and printing costs and costs associated with third-party production of goods. They also include shipping costs and indirect overhead.

Due to the nature of the Company's operations, a majority of its assets are utilized across all segments. In addition, segment assets are not reported to, or used by, the CODM to allocate resources or assess performance of the Company's segments. Accordingly, the Company has not disclosed asset information by segment.
The Company’s segments are determined based on the products and services it provides and how the CODM evaluates the business. The Company has the following reportable segments:
Consumer - Includes sales from the Company's brands and are derived from the sale of 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 its BorrowLenses brand.
Enterprise - Includes revenues primarily from variable, four-color direct marketing collateral manufactured and fulfilled for business customers.

In addition to the above reportable segments, the Company has a corporate category that includes activities that are not directly attributable or allocable to a specific segment. This category consists of stock-based compensation and amortization of intangible assets.

 
 
Three Months Ended September 30,
 
Nine Months Ended September 30,
 
 
2015
 
2014
 
2015
 
2014
 
 
(in thousands)
Consumer
 
 
 
 
 
 
Net revenues
 
$
138,025

 
$
127,299

 
$
458,087

 
$
408,072

Cost of net revenues
 
82,760

 
73,845

 
246,925

 
212,503

Gross profit
 
$
55,265

 
$
53,454

 
$
211,162

 
$
195,569

Gross profit as a percentage of net revenues
 
40
%
 
42
%
 
46
%
 
48
%
 
 
 
 
 
 
 
 
 
Enterprise
 
 
 
 
 
 
 
 
Net revenues
 
$
29,467

 
$
14,709

 
$
53,262

 
$
30,183

Cost of net revenues
 
22,566

 
12,173

 
42,699

 
25,651

Gross profit
 
$
6,901

 
$
2,536

 
$
10,563

 
$
4,532

Gross profit as a percentage of net revenues
 
23
%
 
17
%
 
20
%
 
15
%
 
 
 
 
 
 
 
 
 
Corporate
 
 
 
 
 
 
 
 
Net revenues
 
$

 
$

 
$

 
$

Cost of net revenues
 
2,665

 
3,708

 
9,721

 
11,250

Gross profit
 
$
(2,665
)
 
$
(3,708
)
 
$
(9,721
)
 
$
(11,250
)
 
 
 
 
 
 
 
 
 
Consolidated
 
 
 
 
 
 
 
 
Net revenues
 
$
167,492

 
$
142,008

 
$
511,349

 
$
438,255

Cost of net revenues
 
107,991

 
89,726

 
299,345

 
249,404

Gross profit
 
$
59,501

 
$
52,282

 
$
212,004

 
$
188,851

Gross profit as a percentage of net revenues
 
36
%
 
37
%
 
41
%
 
43
%

21

SHUTTERFLY, INC.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS


Note 11 — Commitments and Contingencies

Build-to-Suit Leases

During the year ended December 31, 2013, the Company executed a lease for a new 237,000 square foot production facility in Tempe, Arizona. This facility consolidated all of the Company's locations in the greater Phoenix area, including the acquired R&R Images facility, offers flexibility for future expansion, and became operational in the second quarter of 2015. Both the landlord and the Company incurred 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. The Company increased the asset and financing obligation for building uplift costs incurred by the landlord during the construction period. During the nine months ended September 30, 2015 and the year ended December 31, 2014, the landlord incurred $17.1 million and $9.1 million of building construction costs, including capitalized interest, respectively, which the Company has recorded as an asset, with a corresponding construction financing obligation, as a component of other non-current liabilities.

Upon completion of the construction of the facility in Tempe, Arizona in the second quarter of 2015, 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 net revenues) 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. In conjunction with the consolidation of facilities in the greater Phoenix area to the Company's new Tempe facility, the Company incurred $1.7 million in early termination costs in the second quarter for 2015, which is included in cost of net revenues in the Company's consolidated statements of operations.

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, 2015, 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)

22

SHUTTERFLY, INC.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

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, 2015, 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.

Legal Matters

The Company is subject to the various legal proceedings and claims discussed below as well as certain other legal proceedings and claims that have not been fully resolved and that have arisen in the ordinary course of business. Although adverse decisions (or settlements) may occur in one or more of these proceedings, it is not possible to estimate the possible loss or losses from each of these proceedings. The final resolution of these proceedings, individually or in the aggregate, is not expected to have a material adverse effect on the Company's business, financial position or results of operations. Cases that previously were disclosed may no longer be described because of rulings in the case, settlements, changes in our business or other developments rendering them, in our judgment, no longer material to our business, financial position or results of operations.

The State of Delaware v. Shutterfly, Inc.

On May 1, 2014, the state of Delaware filed a complaint against the Company for alleged violations of the Delaware False Claims and Reporting Act, 6 Del C. § 1203(b)(2). The complaint asserts that the Company failed to report and remit to Delaware cash equal to the balances on unused gift cards under the Delaware Escheats Law, 12 Del. C. § 1101 et seq. The Company believes the suit is without merit.

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


23


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

CAUTIONARY NOTE REGARDING FORWARD-LOOKING STATEMENTS

This report, including the following Management’s Discussion and Analysis of Financial Condition and Results of Operations, contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934 that are based upon our current expectations. These forward-looking statements include statements related to our business strategy and plans, restructuring activities, technology initiatives, the seasonality of and growth of our business, the impact on us of general economic conditions, trends in key metrics such as total number of customers, total number of orders, and average order value, our capital expenditures for 2015, the sufficiency of our cash and cash equivalents and cash generated from operations for the next 12 months, our operating expenses remaining a consistent percentage of our net revenues, our manufacturing capabilities, our new production facilities, effective tax rates, outstanding convertible senior notes, stock repurchase program as well as other statements regarding our future operations, financial condition and prospects and business strategies. In some cases, you can identify forward-looking statements by terminology such as “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 trusted premium lifestyle brands:  Shutterfly, Tiny Prints, Wedding Paper Divas, ThisLife, MyPublisher, BorrowLenses and Groovebook.  

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, Tempe, Arizona, and Shakopee, Minnesota 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

24


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.

In the first quarter of 2015, we decided to discontinue the Treat brand. Treat was originally launched as an early stage growth initiative over three years ago, and during that time we invested in building a distinct one-to-one card experience that has delighted our customers, but that failed to attract a large enough standalone user base. As of March 2015, customers were no longer able to place orders on Treat.com and they are now redirected to Shutterfly.com where we will enhance the one-to-one card experience under our flagship brand identity.

In the second quarter of 2015, we continued our initiative to build the next generation of Shutterfly, Shutterfly 3.0. We began to intentionally slow investments and innovation in the Tiny Prints and Wedding Paper Divas technology to redirect resources to the new Shutterfly platform, which will allow these brands to be supported by a common set of shared technology services, including cart, creation paths, login, address book and media storage platform. We expect these efforts to continue throughout 2015.

In the second quarter of 2015, we entered into a multi-year agreement with a Fortune 50 enterprise customer. We will continue to make investments in our enterprise platform and seek additional partnerships.

In the third quarter of 2015, we closed our manufacturing operations at the Elmsford, New York facility which was acquired with the MyPublisher acquisition. Although the Elmsford team produced a high quality product, the small size of the facility relative to our other facilities limited its ability to scale and drive efficiencies. The manufacturing work done in Elmsford transitioned to our Fort Mill, Shakopee and Tempe facilities during the third quarter of 2015.

Basis of Presentation

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

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.

In the second quarter of 2015, we changed our accounting estimate related to flash deal deferred revenue. Beginning in 2010, we began to market product offers on flash deal websites such as Groupon and LivingSocial. With limited history as to customer redemption patterns, we had been deferring all amounts to our flash deal deferred revenue liability until customer redemption. We now have sufficient relevant historical flash deal redemption data to support a change in estimate of the flash deal deferred revenue based on historical customer redemption patterns. The historical data supports the probability of redemption after two years from the issuance of a flash deal offer as remote. In addition, our attempts to re-market the unredeemed flash deals over the last six months resulted in no meaningful change in customer behavior. Accordingly, flash deal breakage revenue is now recognized based upon our historical redemption patterns and represents the unredeemed flash deal offers for which we believe customer redemption is remote and it is not probable that we have an obligation to escheat the value of the flash deal revenue under unclaimed property laws. In the second quarter of 2015, we recognized a revenue catch-up of $7.5 million associated with this change.

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 in expanding our presence in this market.

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


25


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 a quarterly 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.      Our cost of net revenues is split between our Consumer and Enterprise segments and our Corporate category.

Consumer.    Cost of net revenues for the Consumer segment consists of costs directly attributable to the production of personalized products for all of our brands, including direct materials (the majority of which consists of paper, ink, and photo book covers), shipping charges, packing supplies, distribution and fulfillment activities, third-party costs for photo-based merchandise, and payroll and related expenses for direct labor and customer service; rent for production facilities, and depreciation of production equipment and facilities where we are the deemed owner. Cost of net revenues also includes 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.

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

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

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

Technology and development expense consists primarily of personnel and related costs for employees and contractors engaged in the development and ongoing maintenance of our 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 data storage for our 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

26


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 consist 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.

In the second quarter of 2015, we changed our accounting estimate related to flash deal deferred revenue. Beginning in 2010, we began to market product offers on flash deal websites such as Groupon and LivingSocial. With limited history as to customer redemption patterns, we had been deferring all amounts to our flash deal deferred revenue liability until customer redemption. We now have sufficient relevant historical flash deal redemption data to support a change in estimate of the flash deal deferred revenue based on historical customer redemption patterns. The historical data supports the probability of redemption after two years from the issuance of a flash deal offer as remote. In addition, our attempts to re-market the unredeemed flash deals over the last six months resulted in no meaningful change in customer behavior. Accordingly, flash deal breakage revenue is now recognized based upon our historical redemption patterns and represents the unredeemed flash deal offers for which we believe customer redemption is remote and it is not probable that we have an obligation to escheat the value of the flash deal revenue under unclaimed property laws. In the second quarter of 2015, we recognized a revenue catch-up of $7.5 million associated with this change.

The Company’s analysis of the need for a valuation allowance considered that the Company has incurred a cumulative loss in the U.S. over the three year period ending September 30, 2015. A majority of the cumulative loss has been caused by non-recurring cost related to the Company’s expansions in manufacturing capacity, restructuring and integration activities in the past few years to prepare for future growth. The Company anticipates a return to full year profitability in fiscal 2016. Consideration has also been given to the Company’s history of utilizing Federal tax loss carryforwards prior to expiration, the expected reversal dates of the significant deferred tax liabilities, i.e., within the federal NOL and R&D credit carryforward periods, inclusive of any IRC Section 382 limitations.
Based on the Company’s assessment, excluding the valuation allowance recorded prior to September 30, 2015 related to certain California and South Carolina deferred tax assets that are not likely to be realized, it is more likely than not that the Company’s other U.S. net deferred tax asset will be realized through future taxable earnings, and/or the reversal of existing taxable temporary differences. If necessary, the Company would pursue any possible tax planning strategies to avoid the valuation allowance. Accordingly, no additional valuation allowance has been recorded on this net asset as of September 30, 2015. The Company will continue to assess the need for a valuation allowance in the future.
If future results are less than projected in the U.S. and if tax planning alternatives do not offset those effects, a valuation allowance may be required to reduce the deferred tax asset, which would impact the Company’s results of operations in the period in which it is recorded.
Our critical accounting policies and estimates are discussed in our Annual Report on Form 10-K for the fiscal year ended December 31, 2014.



27


Results of Operations

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

 
Three Months Ended
 
Nine Months Ended
 
September 30,
 
September 30,
 
2015
 
2014
 
2015
 
2014
Net revenues
100
 %
 
100
 %
 
100
 %
 
100
 %
Cost of net revenues
64
 %
 
63
 %
 
59
 %
 
57
 %
Gross profit
36
 %
 
37
 %
 
41
 %
 
43
 %
Operating expenses:
 

 
 

 
 
 
 
Technology and development
23
 %
 
24
 %
 
22
 %
 
22
 %
Sales and marketing
26
 %
 
30
 %
 
27
 %
 
29
 %
General and administrative
16
 %
 
18
 %
 
17
 %
 
18
 %
Total operating expenses
65
 %
 
72
 %
 
66
 %
 
69
 %
Loss from operations
(29
)%
 
(35
)%
 
(25
)%
 
(26
)%
Interest expense
(3
)%
 
(3
)%
 
(3
)%
 
(3
)%
Interest and other income, net
 %
 
 %
 
 %
 
 %
Loss before income taxes
(32
)%
 
(38
)%
 
(28
)%
 
(29
)%
Benefit from/(provision for) income taxes
(5
)%
 
5
 %
 
1
 %
 
4
 %
Net loss
(37
)%
 
(33
)%
 
(27
)%
 
(25
)%

Comparison of the Three Month Periods Ended September 30, 2015 and 2014
 
Three Months Ended September 30,
 
2015

2014

$ Change

% Change
 
(in thousands)
Net revenues
 
 
 
 
 
 
 
Consumer
$
138,025

 
$
127,299

 
$
10,726

 
8
 %
Enterprise
29,467

 
14,709

 
14,758

 
100
 %
Corporate

 

 

 
 %
Total net revenues
$
167,492

 
$
142,008

 
$
25,484

 
18
 %
Cost of net revenues
 
 
 
 
 
 
 
Consumer
$
82,760

 
$
73,845

 
$
8,915

 
12
 %
Enterprise
22,566

 
12,173

 
10,393

 
85
 %
Corporate
2,665

 
3,708

 
(1,043
)
 
(28
)%
Total cost of net revenues
$
107,991

 
$
89,726

 
$
18,265

 
20
 %
Gross profit
 
 
 
 
 
 
 
Consumer
$
55,265

 
$
53,454

 
$
1,811

 
3
 %
Enterprise
6,901

 
2,536

 
4,365

 
172
 %
Corporate
(2,665
)
 
(3,708
)
 
1,043

 
(28
)%
Total gross profit
$
59,501

 
$
52,282

 
$
7,219

 
14
 %
Consumer gross margin percentage
40
%
 
42
%
 

 

Enterprise gross margin percentage
23
%
 
17
%
 

 

Consolidated gross margin percentage
36
%
 
37
%
 

 

Key Consumer Metrics
 
Customers
3,112

 
2,517

 
595

 
24
 %
Orders
5,344

 
4,156

 
1,188

 
29
 %
Average order value
$
25.83

 
$
30.63

 
$
(4.80
)
 
(16
)%


28


Net revenues increased $25.5 million, or 18%, for the three months ended September 30, 2015 as compared to the same period in 2014. Cost of net revenues increased $18.3 million, or 20%, for the three months ended September 30, 2015 as compared to the same period in 2014. As a percentage of net revenues, cost of net revenues increased to 64% in the three months ended September 30, 2015 from 63% in the same period in 2014, which decreased gross margin to 36% in the three months ended September 30, 2015 from 37% in the same period in 2014.

Consumer Segment

Consumer net revenues increased $10.7 million, or 8%, in the three months ended September 30, 2015 compared to the same period in 2014.  The increase in Consumer net revenues was primarily a result of increased sales of photo gifts, Groovebook, and mobile revenue.  The increase is also reflected in the increases in customers and orders in three months ended September 30, 2015, as compared to the same period in 2014. Average order value decreased 16% which reflects Groovebook's lower average order value compared to our core brands and increasing partner promotions as compared to the prior year.

Consumer cost of net revenues increased $8.9 million, or 12%, for the three months ended September 30, 2015 as compared to the same period in 2014, which decreased Consumer gross margin to 40% in the three months ended September 30, 2015 from 42% in the same period in 2014. The decrease in Consumer gross margin percentage from the same period a year ago is largely driven by the expenses of our new Tempe, Arizona production facility which resulted in increases to depreciation and labor costs.

Enterprise Segment

Enterprise net revenues increased $14.8 million, or 100%, in the three months ended September 30, 2015 compared to the same period in 2014. The increase in Enterprise net revenues is primarily due to the expansion of projects with existing customers and the acquisition of new customers.

Enterprise cost of net revenues increased $10.4 million, or 85%, for the three months ended September 30, 2015 as compared to the same period in 2014, which increased Enterprise gross margin to 23% in the three months ended September 30, 2015 from 17% in the same period in 2014. The increase in Enterprise gross margin is primarily due to increased efficiencies as a result of the expansion of projects with our existing customers.

 
Three Months Ended September 30,
 
2015
 
2014
 
$ Change
 
% Change
 
(in thousands)
Technology and development
$
38,066

 
$
33,488

 
$
4,578

 
14
%
Percentage of net revenues
23
%
 
24
%
 

 

Sales and marketing
$
43,052

 
$
42,082

 
$
970

 
2
%
Percentage of net revenues
26
%
 
30
%
 

 

General and administrative
$
27,449

 
$
25,639

 
$
1,810

 
7
%
Percentage of net revenues
16
%
 
18
%
 

 


Our technology and development expense increased $4.6 million, or 14%, for the three months ended September 30, 2015, compared to the same period in 2014. As a percentage of net revenues, technology and development expense decreased to 23% in the three months ended September 30, 2015 from 24% in the three months ended September 30, 2014. The overall increase was primarily due to an increase of $2.0 million in personnel and related costs due to increased headcount and an increase of $1.2 million in professional fees. The increase in technology and development expense was also due to an increase of $1.1 million in depreciation expense and an increase in stock-based compensation expense of $0.8 million. These factors were partially offset by a decrease of $0.6 million in facilities costs and an increase of $0.2 million in software and website development costs capitalized.

At September 30, 2015, headcount in technology and development increased by 9% compared to September 30, 2014, 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, 2015, we capitalized $5.9 million in eligible salary and consultant costs, including $0.3 million of stock-based compensation, associated with software developed or obtained for internal use, compared to $5.7 million capitalized in the three months ended September 30, 2014, which included $0.7 million of stock-based compensation expense.


29


Our sales and marketing expense increased $1.0 million, or 2%, in the three months ended September 30, 2015 compared to the same period in 2014. As a percentage of net revenues, total sales and marketing expense decreased to 26% in the three months ended September 30, 2015 from 30% in the three months ended September 30, 2014. The increase in our sales and marketing expense was due to an increase of $0.9 million related to our integrated marketing campaigns which included increased marketing partnerships and increased online and television advertising and an increase of $0.6 million in personnel and related costs due to an increase in headcount. These factors were partially offset by a decrease of $0.3 million of stock-based compensation expense.

Our general and administrative expense increased $1.8 million, or 7%, in the three months ended September 30, 2015 as compared to the same period in 2014. As a percentage of net revenues, general and administrative expense decreased to 16% in the three months ended September 30, 2015 from 18% in the three months ended September 30, 2014. The increase in general and administrative expense was primarily due to an increase of $1.0 million in stock-based compensation expense and an increase of $0.8 million in salary and personnel related costs as a result of increased headcount. There was also an increase of $0.8 million in credit card fees driven by an increase in Consumer net revenues as compared to the prior year, an increase of loss on asset disposition of $0.5 million, and a decrease of $0.2 million in proceeds from intellectual property license agreements. The increase in general and administrative expense was partially offset by a decrease of $0.9 million in professional fees and a decrease of $0.8 million in depreciation expense.
 
Three Months Ended September 30,
 
2015
 
2014
 
Change
 
(in thousands)
Interest expense
$
(5,613
)
 
$
(4,381
)
 
$
(1,232
)
Interest and other income, net
433

 
102

 
331


Interest expense consists of interest on our convertible senior notes, amortization of the 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, Shakopee, Minnesota, and Tempe, Arizona which became operational in the second quarter of 2015. Interest expense was $5.6 million for the three months ended September 30, 2015 compared to $4.4 million during the same period a year ago.
 
Three Months Ended September 30,
 
2015
 
2014
 
(in thousands)
Income tax benefit/(provision)
$
(8,831
)
 
$
6,962

Effective tax rate
(16
)%
 
13
%

We recorded an income tax provision of $8.8 million and an income tax benefit of $7.0 million for the three months ended September 30, 2015 and 2014, respectively. Our effective tax rate was (16)% for the three months ended September 30, 2015, compared to 13% for the three months ended September 30, 2014. 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. Our quarterly tax expense is highly sensitive to changes to our estimated effective tax rate for the year due to the near break-even taxable income.  The change in the effective tax rate and the tax expense for the three months ended September 30, 2015 was primarily attributable to the change in our estimated effective tax rate for the full year.

 
Three Months Ended September 30,
 
2015
 
2014
 
$ Change
 
% Change
 
(in thousands)
Loss before income taxes
$
(54,246
)
 
$
(53,206
)
 
$
(1,040
)
 
2
%
Net loss
(63,077
)
 
(46,244
)
 
(16,833
)
 
36
%
Percentage of net revenues
(37
)%
 
(33
)%
 

 


During the three months ended September 30, 2015, net loss was $63.1 million, an increase of $16.8 million as compared to a net loss of $46.2 million the same period in 2014. As a percentage of net revenues, net loss increased to 37% for the three months ended September 30, 2015 from 33% for the three months ended September 30, 2014.


30


Comparison of the Nine Month Periods Ended September 30, 2015 and 2014
 
Nine Months Ended September 30,
 
2015
 
2014
 
$ Change
 
% Change
 
(in thousands)
Net revenues
 
 
 
 
 
 
 
Consumer
$
458,087

 
$
408,072

 
$
50,015

 
12
 %
Enterprise
53,262

 
30,183

 
23,079

 
76
 %
Corporate

 

 

 
 %
Total net revenues
$
511,349

 
$
438,255

 
$
73,094

 
17
 %
Cost of net revenues
 
 
 
 
 
 
 
Consumer
$
246,925

 
$
212,503

 
$
34,422

 
16
 %
Enterprise
42,699

 
25,651

 
17,048

 
66
 %
Corporate
9,721

 
11,250

 
(1,529
)
 
(14
)%
Total cost of net revenues
$
299,345

 
$
249,404

 
$
49,941

 
20
 %
Gross profit
 
 
 
 
 
 
 
Consumer
$
211,162

 
$
195,569

 
$
15,593

 
8
 %
Enterprise
10,563

 
4,532

 
6,031

 
133
 %
Corporate
(9,721
)
 
(11,250
)
 
1,529

 
(14
)%
Total gross profit
$
212,004

 
$
188,851

 
$
23,153

 
12
 %
Consumer gross margin percentage
46
%
 
48
%
 

 

Enterprise gross margin percentage
20
%
 
15
%
 

 

Consolidated gross margin percentage
41
%
 
43
%
 

 


Net revenues increased $73.1 million, or 17%, for the nine months ended September 30, 2015 as compared to the same period in 2014. Cost of net revenues increased $49.9 million, or 20%, for the nine months ended September 30, 2015 as compared to the same period in 2014. As a percentage of net revenues, cost of net revenues increased to 59% in the nine months ended September 30, 2015 from 57% in the same period in 2014, which decreased gross margin to 41% in the nine months ended September 30, 2015 from 43% in the same period in 2014.

Consumer Segment

Consumer net revenues increased $50.0 million, or 12%, in the nine months ended September 30, 2015 compared to the same period in 2014.  The increase in Consumer net revenues was primarily a result of increased sales of calendars, Groovebook