Shutterfly's IPO Isn't Picture Perfect

Online photo service has registered to go public. The picture looks sharpbut is it sharp enough?

On the face of things, Shutterfly's registration for an initial public offering presents the kind of profile of strong revenue growth and profitability that IPO investors look for. In a Securities & Exchange Commission filing dated June 29, Shutterfly reported revenues of $83.9 million in 2005, up from about $55.5 million the year before. The company's net income hit $28.9 million in 2005, compared with $3.7 million a year earlier. That puts net margins at an unusually rich 34%.

But the company's finances are not as strong as they look at first glance—and real profitability is not improving nearly as fast as Web companies at a similar stage can usually achieve. Plus, rivals, owned by Hewlett-Packard (HPQ), and Eastman Kodak's (EK) are at least as large, as fast-growing, and as highly regarded as Shutterfly, depriving the Redwood City (Calif.) startup of any first-mover advantage that would lead to much fatter margins down the road.

All three outfits compete in the business of running sites where consumers can post their snapshots from digital cameras for free, and pay for prints of the pictures they like most. The rivals also sell photo-themed gifts, from Christmas cards to mouse pads and sweatshirts.


  Before you break out the checkbook to buy shares, Shutterfly's fat 2005 profit isn't all it appears to be. More than $24 million came from a one-time tax benefit and another $400,000 represented a "change in accounting principles." For the past three years, Shutterfly has basically been a 55%-gross-margin business, which gives the company room to make money if they can contain technology and marketing spending as revenues rise. But so far they haven't. Operating margins have declined slightly, to 6% of revenues from 7%, even as the company doubled in size. That's why 2003 operating profits of $2.1 million grew only to $4.4 million by last year. That's pretty ho-hum for a growth company just passing the tipping point into profitability.

When news broke earlier this week that Shutterfly wanted to either go public or sell itself, a source told The Wall Street Journal that Shutterfly makes $20 million to $25 million before interest, taxes, depreciation, and amortization. A company spokeswoman declined comment, citing SEC restrictions on public statements before a securities offering. That estimate may be too high, or at least it assumes very fast growth this year. The SEC filing says relatively heavy capital spending for a company this size has so far kept Shutterfly's free cash flow from growing any faster than revenue. Free cash flow, which is operating cash flow minus capital spending, went from $5.7 million in 2004 to only $7.7 million last year. So how it's going to get to $20 million or $25 million by yearend is a mystery, especially since Shutterfly burned cash on operations during the seasonally slow first quarter.

The bigger problem may be competition. In tests conducted this year by PC World magazine, Kodak's site won the highest ratings for value and user-friendliness. The magazine rated all three major sites close together, with KodakGallery's rating of 80 on a 100-point scale, ahead of Snapfish's 77 and Shutterfly's 75.


  But Snapfish has been the player gaining the most market share, insists Ben Nelson, general manager of online photo-sharing for HP. The key innovation: partnerships with huge retailers such as Walgreen (WAG) and Costco (COST) that let Snapfish users order photos at Snapfish and pick up prints as little as an hour later at their local store. Snapfish, whose financial results are not broken out by HP, is adding erstwhile rival and retail giant Wal-Mart (WMT) as a partner, effective this fall. Sniffs Nelson at Shutterfly's numbers: "Not great growth."

By contrast, Shutterfly users have to wait while Shutterfly, which owns its own printing facility in Hayward, Calif., prints the photos and mails them out. The company's SEC filing says this helps Shutterfly "ensure high-quality products, maintain a favorable cost structure, and ensure timely shipment to customers." But the editors of PC World cited the "lack of pickup options" in awarding Shutterfly the lowest score of the industry's big three.'s own reviews of the three photo sites were more favorable for Shutterfly. While the reviews don't have the same quantitative metrics that PC World uses, the photo site did receive three-and-a-half stars out of five (see, 10/5/05, "See Shutterfly: A Snap to Use"). The review called Shutterfly "well-designed" and "good for sharing," though it also said it was "pricier than some" with "so-so print quality."


  Shutterfly's insistence on controlling its own printing operation accounts for the company's heavy capital spending. And its SEC filing shows that it has been pressured by rivals' price-cutting, which has forced the price of basic prints to as little as 12 cents each, from 29 cents in the second quarter of 2005. "You don't win in this business on features," Nelson says. "You win based on your business model."

The Wall Street Journal also reported that Shutterfly wants a valuation between $400 million and $500 million. That's a multiple between 52 times and 65 times last year's free cash flow, a result that may be as unlikely as some photos of your Uncle Fred from his college reunion. Shutterfly's numbers point to a distinctly lower valuation than that. Indeed, it may mean there is no IPO at all. The search for enough pure size to get economies of scale may well force Shutterfly to hook up with a competitor before it ever goes public.

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