Shutterfly: A Value Investment? Not in My Book

In last week's edition of Value Investor Insight, the newsletter featured a bullish piece on Shutterfly, Inc. (SFLY) from investor Mario Cibelli of Marathon Partners. Cibelli made a compelling case for NFLX in a 2006 edition of VII when everyone else said that the DVD-by-mail model could never compete in an industry that would quickly move to streaming movies and put the company in direct competition with AMZN, Blockbuster and others. He saw NFLX as a "disruptive" business with a competitive advantage that would succeed. He was correct, and as you may know, shares of NFLX have soared to around $150 as of the writing of this article.

Cibelli sees SFLY as his next big "disruptive" bet in an industry that "is in the early stages of significant growth...[in which] it is Shutterfly's business to lose..." Cibelli believes that SFLY has been "the most aggressive innovator" in the space based on their moves from low margin 4x6 prints to higher margin photo books and the "Simple Path" method of uploading pictures to photo books that takes a fraction of the time it takes to create an entire custom book. He also believes that as times goes on, if SFLY is able to maintain their "30% share of the [photo printing] business - the company would more than double revenues" based on what US consumers spend annually on greeting cards, photos and photo books.

However, Cibelli's argument fails to make take into account some very important aspects of the business that not only don't make it a value investment, but at these levels, I believe it to be a decent short candidate.

1. SFLY makes what is essentially a commodity product on the internet with paper thin margins;
2. Their "innovations" have been and can continue to be copied by competitors (both existing and new) that are constantly engaged in pricing and promotional wars with each other;
3. The Company produces minimal to no cash flow outside Q4 (holiday season);
4. Primarily has machines that don't run 3/4 of the year (w/ the exception of small commercial printing biz);
5. Trades at a current 110x earnings and 50x next year's earnings (admittedly SFLY has high depreciation expense, but almost equally high CapEx, so cash flow is only marginally positive from an accounting perspective);
6. Analyst projections are far too high.

Commoditized Product
While I believe that SFLY offers a quality product and has thousands of satisfied customers, every one of their existing products as well as recent "innovations" on their site are easily copied. This is the most important part of the SFLY short story in my mind; if there is no competitive moat, how can an investor expect historical growth to continue AND how will they grow margins? If they can't do this, why pay a premium multiple for the shares?

For a starting example, look at a site such as picasa.com (popular google service for online photo sharing). Shutterfly is undifferentiated from the other listed printing options, leaving price as the only differentiating factor in this equation if you are not already an SFLY customer. Additionally, there are OVER 100 similar online photo printing sites like those below:

click to enlarge

When asked what differentiated their products from the competition, SFLY management told me that their product has a better feel - the fact that the pictures (or photo books) come in a higher quality, heavier duty box when delivered. Prodded further, the stated that site innovations (such as "Simple Path") have also differentiated them from their competition. While I respect the fact that SFLY tries to differentiate with a higher quality product, they don't hold patents in their photo processing, their delivery method nor their other services and as a result, have seen margins on 4x6 printing erode significantly. There have been constant price wars in the 4x6 print space, with competitors undercutting SFLY's price.

Here's a good synopsis of developments in the 4x6 price war that has ensued over the last several years. With prints as low as 5c/print, there's not a lot of room for margin...add in free shipping to that (as advertised above by American Greetings) and you're practically giving them away...it should be noted that in 2009, shipping accounted for 14% of SFLY's revenue. Continued attempts to undercut shipping costs are a further threat to SFLY.

As innovators, SFLY has attempted to find a growth engine beyond the low margin 4x6 business by introducing the personalized photo book as a way to store memories in a more customized, lasting manner. Over the last several years, custom products like photo books, greeting cards and calendars have become increasingly important to SFLY as seen in the revenue breakdown below:

However, there is also nothing to keep competitors out of the photo book and customized space either and SFLY runs a high risk of these albums becoming yet another commodity product. You can see HERE that there are already several competitors in the space at a lower price point than SFLY, including Snapfish (HPQ), the main driver behind the 4x6 price wars that eroded margins to where they are today (here, here and here are some direct examples of the competition, congrats if you can spot the differences...). As these personalized products are brought down in price by competition, SFLY's margins on these products will erode just as they did in the 4x6 prints.

Although only anecdotal in nature, SFLY is offering non-holiday related 20% discounts on ALL photo books right now. As of two weeks ago, this deal was supposed to end Sept. 29, but has been extended through October 13. According to Morgan Keegen, which covers SFLY, photo book pricing has been decreasing steadily over the past several weeks. While this may be a positive in bringing new customers, it's still a negative when it comes to margins.

Speaking of margins, they're paper thin. While they have increased markedly over the last two years since the economy began sinking, gross margin, EBITDA, EBIT and net margins are all flat to down significantly since 2004, a result of continually squeezed margins of a commodity product. While SFLY's 5 year Revenue CAGR as of YE2009 was over 35%, EPS had grown at barely half that rate. Cibelli says in the article that he "honestly believes this is a $1 billion revenue business" and "at that revenue level, his price target for the shares goes to $100." Let's do the math with max margins from 2004 as well as current margins and see where that business would trade:

At current margins, SFLY is certainly no value. If the company can somehow keep out the competition, which has only grown more numerous over the years, innovate and grow all margins by 50-200%, there is a chance that shares could be reasonably priced on an EV/EBITDA basis, but still expensive on earnings to be called "value". At today's margins, Ben Graham would spin in his grave and Warren Buffett would have a cardiac episode if you tried to pitch this as a "value" name.

4th Quarter or Bust

SFLY has negative EPS and earns almost no cashflow outside of their fiscal 4th quarter, where revenues triple from the other quarters and positive EPS covers the losses of the previous 4 quarters in order to make SFLY have a positive P/E. It also produces enough cash flow to cover the other quarters and make SFLY trade at a high, but not ghastly 17.5x FY09 FCF (For simplicity sake, I'm using a calc of CFO-CapEx).

While this in itself is not a huge problem, it means the 4th quarter is very important to the business and any sort of hiccup is problematic. On the 2Q conference call, CFO Mark Rubash described "moderation in activity" in late 2Q and into early 3Q. While the site's traffic appears to have picked back up somewhat (according to compete.com), current non-holiday related discounts being offered on their highest margin products do not bode well for a strong 3Q and given current consumer confidence, this also may not be the merriest of holiday seasons either. According to management (and common sense), SFLY's performance is highly correlated to consumer sentiment and confidence, which has been wanning over the last several months.

To solve some of their fixed cost issues, SFLY has begun a fledgling commercial printing business, although management has admitted it is taking longer to get off the ground than expected. While they think the business can do $30-40MM in sales, the sales would be lower margin than the core picture printing business. SFLY only has a few sales people devoted to this effort, which will likely keep revenue growth slow; slim margins due to fixed costs will likely remain in this business line for the foreseeable future.

Valuation and Expectations Too High

Currently trading at around 110x current year expected earnings, SFLY is expensive on an earnings basis...even next year's consensus earnings puts them at a P/E of 47. Given the company's high depreciation asset base, high P/E will continue to be an issue for SFLY. Although not unreasonable on an EV/EBITDA basis at around 14.5x, it's still not exactly a "value" discount. Additionally, growth has been continually slowing over the past several years as both two year and three year CAGR in revenue, gross profit, EBITDA and net income have declined since the company went public.

In addition to an already expensive valuation, analyst estimates are far too high based on historical performance as well as what will ultimately remain a highly competitive market for online photo printing. Although covered by several major houses (JPM, MS, Lazard, etc.), many analysts only put out one report each quarter at earnings time, so SFLY is generally neglected by the analyst community. As a result, sell-side estimates contemplate top line growth that may (emphasis on "may) be attainable, but margins that unlikely based on how business has trended over the last 5 years. Below are street consensus estimates for the next 5 years:

In order to meet these estimates, there is going to have to be both substantial growth in order prices as well as growth in household penetration. To give you a macro picture of what this would look like, assume that SFLY has 33% mkt share (last number I've heard from Company) and an average order price that grew 8% (average of '07-'09) over 2009 (and continues to grow at this level), this would mean that based on growth expectations of total US households, one in every 4 to 5 houses would need to be placing a photo order per year and for SFLY, these orders and the prices would need to be growing at a steady clip as well.

While this level of growth may not seem overly taxing for SFLY, consider that the competition is fierce for these dollars, household penetration would need to grow almost 40%, keeping other things constant and one in every 10 households would need to make an "average" price order from SFLY. Then consider that their core customer base is women, age 25-45 with $95K household income. Unless they can broadly expand the demographic base of their highly discretionary and pricey item or get their core demographic to really up their order values per year, it's going to be tough to meet these estimates.

Risks to Short Idea

SFLY has a pristine balance sheet with $5.83 in cash and no debt, which serves as a support to the shares. Under circumstances with a business I felt more attraction to from a valuation and competitive moat perspective, I would be lauding their balance sheet, but with a "growing" tech company such as SFLY, it is doubtful this cash would ever be put back into shareholder's hands as dividends or share buybacks...in fact, shares outstanding have been steadily increasing since the company went public due to their egregiously large SBC plan. At best, they keep the cash, at worst, they make a "strategic" acquisition.

SFLY's market cap makes it vulnerable to be bought out by a competitor (like Snapfish). I highly doubt the company would be a target for either private equity or management led buyout due to their lumpy earnings and cash flow that is almost wholly dependent on one quarter of operations. I also doubt that a PE firm could get comfortable with the competitive "advantages" that SFLY claims to have.

For all the reasons above, I believe that not only is SFLY not a true value, but I am short the shares at these levels with expectations that analyst estimates are going to be tough to beat going forward. While Cibelli may have knocked it out of the park with his call on NFLX, what made that business "disruptive" is that they did something nobody else had ever done - create a profitable subscription based DVD service that ended up not being threatened as quickly as expected by existing titans of the rental and online business. SFLY is different in that they are doing something that 100 other competitors are doing right now and in a manner that can only be differentiated for a short period of time before competitors cross the moat. Imagine if there were 100 other DVD subscription services out there right now...the competition would be fierce, price wars would be commonplace and you certainly wouldn't pay the 60x earnings attached to NFLX these days...now imagine paying 100x earnings for that business; that is SFLY.

Disclosure: None